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Over the next several months you will hear a great deal about the new Roth 401(k). This new savings option will allow you to save after tax dollars in your 401(k) plan, have the earnings grow tax free and then withdraw your money tax free to spend in retirement after the age of 59˝ if the account has been held for at least 5 years.
Your regular 401(k) program allows you to deduct money for retirement savings and grow your money tax deferred. When you retire, you will be taxed on the amount of money you withdraw at the tax rate you have in retirement.
The Roth 401(k) and a regular 401(k) have minimum distribution rules that you will have to follow once you reach 70 ˝ years old. With a regular IRA there are minimum distribution rules as well. However, a Roth IRA does not have required minimum distributions. Based on the above rules, most people who establish a Roth 401(k) may later roll their account into a Roth IRA. This can give them more flexibility in retirement as it relates to how and when they withdraw money to spend in retirement.
Which one is the better economic deal?
We decided to test which 401(k) works out better when it comes time to retire. We modeled two people saving for retirement. Client one used a regular 401(k) and Client two used the Roth 401(k). Both people saved $5,000 per year for twenty years and received an average rate of return of 7%. We also assume that both Clients have a marginal tax rate of 30% both during their saving years as well as in retirement.
At the end of the accumulation period, both Clients retired and completely spent down their accounts. We found that in the above fact pattern both Clients had $15,750 per year to spend.
Client one who used a regular 401(k) was able to save $5,000 per year. In retirement, they would have to withdraw $22,500 per year, pay $6,750 in taxes to end up with $15,750. Client two who decided to use a Roth 401(k) was able to only save $3,500 per year because they would have to pay $1,500 per year in taxes on the money that was saved. However, Client two would not have to pay any taxes in retirement on their Roth account which allowed them to only withdraw $15,750 per year from their account.
What if my tax rate is lower in retirement than today?
If you think your tax rate is going to be lower in retirement than it is while you’re saving for retirement, a regular 401(k) may be more beneficial. We re-ran our calculations with Client one. Instead of having a 30% tax rate in retirement, we assumed that Client one’s tax rate would only be 20%. Under this scenario, our Client would still withdraw $22,500 per year. But instead of $6,750 in taxes, they would only have to pay $4,500 per year in taxes. This allowed them the ability to net $18,000 per year or an improvement of $2,250 per year over the Roth 401 (k). Client one would now have a 14% improvement over using a Roth 401(k).
Many financial questions require you to look in the future to see what might change. Many people do have a significantly lower tax rate in retirement than they do while they’re working. Before making a decision on which plan would be more beneficial to you, your financial situation as well as possible changes in the future should be taken into consideration.
When does a Roth 401(k) make sense?
We believe a Roth 401(k) makes sense if you are in a high tax bracket today and are likely to remain in a high tax bracket when you retire. When you retire, you can rollover your Roth 401(k) account to a Roth IRA which does not have any required distributions.
This means that you can continue to accumulate this tax free money for as long as you’re alive. This allows you to accumulate more money in tax preferred accounts than if it was in a regular IRA or 401(k) account.
The decision on whether to use a Roth 401(k) savings account or a regular 401(k) account is complicated. We urge you to contact your financial advisor to learn which option is best for you. We at Stage 2 Planning Partners have spent time reviewing the new Roth opportunity and would be glad to have a face to face discussion about your specific situation.
1If you would like more information or support from our firm, please visit us online or e-mail us and your Stage 2 Associate will get back to you.
With Warm Regards,
Stage 2 Planning Partners
Josh Patrick © 2006
All returns and amounts of money to spend are purely hypothetical. They are not meant as guarantees of returns. Neither Stage 2 Planning Partners nor NFP Securities, Inc. warrants these numbers as accurate. The illustrations used in this article are purely for educational purposes only. If you would like to get a copy of the spreadsheet that illustrates this article, please contact Jpatrick@stage2planning.com
Securities and Investment Advisory Services offered through NFP Securities, Inc., A Broker/Dealer, Member NASD/SIPC and a Federally Registered Investment Advisor.
Stage 2 Planning Partners is an affiliate of National Financial Partners Corp., The parent company of NFP Securities, Inc. Representatives listed on this website are currently registered to conduct securities business in the following states: AZ, CO, CT, FL, IL, IN, MA, MT, NC, NH, NY, PA, RI, VA, VT, WA
NFP Securities is not affiliated with Harris- Murray
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