Reason #5: Maximum Roth 401(k)/403(b) Limit Equates to a $30,769 Pre-tax Contribution - September 15, 2005

In determining if the new Roth 401(k)/403(b) option is preferable when compared to the traditional pre-tax option, the key factor for participants to consider is the tax rate they pay today versus their future tax rate on distributions following retirement. However, participants who wish to maximize their retirement savings (and can afford to) have another factor to consider, one that mitigates the need for predicting future tax rates and simplifies this very complex decision.

Reason #5: The Maximum Roth 401(k) /403(b) Limit Equates to a $30,769 Pre-tax Contribution

If the participant has the desire and ability to contribute the highest permissible contribution to a qualified retirement plan, a maximum after-tax Roth 401(k)/403(b) contribution effectively raises the maximum individual contribution limit. Starting in 2006, an individual age 50 or older who pay taxes at the highest federal rate of 35%, is permitted to contribute up to $20,000 Roth 401(k)/403(b). The $20,000 Roth contribution equates to a $30,769 contribution to a pre-tax account.

This article discusses how to formulate a sound comparison between a maximum contribution to a Roth account and a maximum contribution to a traditional pre-tax account. But before I bend your brain with the algebraic proof for reason #5 of the "Five Reasons Why HCEs Should Choose the Roth 401(k)/403(b)," I'd like to strengthen my case for:

Reason #1: Your future tax rate will be as high or higher than it is today.

Conventional wisdom dictates that it is sensible to think that you will be in a lower tax bracket following retirement. However, is it also sensible to think that the government will increase tax rates? Here's what may occur in the future...

A married participant earns $150,000 annually. In 2006, the participant is in the 28% tax bracket and pays taxes at a rate of 28%. If the participant is in a lower tax bracket during his retirement, does that also mean taxes are paid at a lower rate?

Perhaps not. The table below indicates the tax rates for 2005. Each row of the table represents each "Tax Bracket." The participant’s current tax bracket is indicated in blue.

Tax Rate	Married Filing Joint and Surviving Spouses	Unmarried Individuals	Heads of Households	Married Filing Separate
10%	$0 - 14,600	$0 - 7,300	$0 - $10,450	$0 - 7,300
15%	$14,601- 59,400	$7,301- 29,700	$10,451- 39,800	$7,301- 29,700
25%	$59,401- 119,950	$29,701- 71,950	$39,801- 102,800	$29,701- 59,975
28%	$119,951- 182,800	$71,951- 150,150	$102,801- 166,450	$59,976- 91,400
33%	$182,801- 326,450	$150,151- 326,450	$166,451- 326,450	$91,401- 163,225
35%	over $326,450	over $326,450	over $326,450	over $163,225

The participant retires in 2020 and receives $100,000 per year in taxable income during retirement. Based on the hypothetical tax rates for 2020, it turns out that the participant is in a lower tax bracket. However, even in a lower tax bracket, the participant pays federal income tax at a higher rate.

Tax Rate	Married Filing Joint and Surviving Spouses	Unmarried Individuals	Heads of Households	Married Filing Separate
15%	$0 - 14,600	$0 - 7,300	$0 - $10,450	$0 - 7,300
25%	$14,601- 59,400	$7,301- 29,700	$10,451- 39,800	$7,301- 29,700
33%	$59,401- 119,950	$29,701- 71,950	$39,801- 102,800	$29,701- 59,975
38%	$119,951- 182,800	$71,951- 150,150	$102,801- 166,450	$59,976- 91,400
42%	$182,801- 326,450	$150,151- 326,450	$166,451- 326,450	$91,401- 163,225
45%	over $326,450	over $326,450	over $326,450	over $163,225

Impact on Low and Middle Income Taxpayers In reading many of the articles written to date on the benefits of the Roth, some planning experts point out that individuals in lower income tax brackets may find themselves paying higher tax rates in the future since they will lose deductions for mortgage interest and dependents in their retirement years. The experts I've spoken with do not agree with this reason. However, they do agree that many individuals who are in these brackets today do expect to be paying higher tax rates in the future, since they are currently in positions at the start of their working career or perhaps starting a new one.

Conventional wisdom dictates that the Roth option is financially beneficial to participants whose tax rate is lower when contributions are made versus their tax rate when distributions occur following retirement, since taxes were paid at the lower rate when contributed. Conversely, the pre-tax option is more beneficial to participants whose tax rate is higher when contributing versus when distributions commence following retirement, since taxes are paid at a lower rate when receiving distributions in retirement. Perhaps its time to rethink the conventional wisdom...

If the participant chooses to contribute to the Roth option instead of the pre-tax option, and the participant wants the same net take home pay as the pre-tax option, the Roth contribution is lower than the pre-tax contribution because the participant pays tax on the salary reduction before it is deposited to the Roth account.

Formula: Roth After-tax Contribution = Pre-tax Contribution times (1 - Marginal Tax Rate)

If the participant wants the same dollar amount deposited to the plan as the pre-tax contribution, then his salary reduction is higher and net take home pay is lower when compared to the pre-tax option.

Formula: Roth Salary Reduction = Pre-tax Contribution divided by (1 - Marginal Tax Rate)

If they choose the Roth option, and they want the same net take home pay, the Roth contribution is lower than the pre-tax contribution because they pay tax on their salary reduction before it is contributed to the Roth account, or simply stated...

If they want the same dollar amount contributed to their Roth account as they would contribute to a pre-tax account, their net take home pay is lower because the salary reduction is higher to pay federal income taxes before the contribution is deposited into the plan, or simply stated...

Example 1: Same Net Pay Means Lower Roth Contribution Sam is age 51 and earns $350,000 annually; however, for retirement plan purposes, his compensation is capped at $215,000 (the projected 2006 compensation limit). He pays taxes on his last dollars earned at the federal rate of 35%. He defers 9.3% of compensation, or $20,000, into a pre-tax 401(k) account. If Sam wants to have the same net pay after contributing to the Roth option, what is his after-tax Roth contribution?

If Sam wants to receive the same net pay check, he reduces his pay by the same gross amount of $20,000. He pays $7,000 in tax on the $20,000 (35%) and contributes $13,000 to the plan. The formal calculation is performed as follows:

Example 2: Same Roth Contribution Means Higher Salary Reduction Same facts as the previous example except Sam contributes $20,000 to the Roth account. If Sam contributes the $20,000 maximum to the Roth account, what is his salary reduction?

Sam reduces his pay by $30,679, pays $10,769 in tax (35%) and contributes $20,000 after-tax to the Roth account. The formal calculation is performed as follows:

Is it advisable for Sam to contribute the $20,000 maximum to the Roth account?

Let's first examine the prospective future changes in Sam's marginal tax rate (MTR) and their impact on his total after-tax retirement distributions resulting from 5 years of the $13,000 contributions to the Roth account compared to $20,000 contributions to the pre-tax account.

The graphic illustrations below assume 3% annual cost-of-living adjustments and the corresponding increases in the individual 401(k)/403(b) and catch-up limits for each year through 2010 (subject to $500 minimum increment increases). In both instances, Sam receives equal periodic payments over his life expectancy starting at retirement. The illustration also assumes that the Roth IRA distributions are qualified and thus, tax-free. The rate of return for the 401(k) account is based on a portfolio consisting of 60% stocks earning 8%, and 40% bonds earning 5.5%. The rate of return for the side fund is based on a portfolio consisting of 60% stocks earning 8% taxed annually at 15%, and 40% bonds earning 4% tax-free. Both the Roth and the pre-tax contribution are subject to FICA taxes for Social Security and Medicare benefits, and any applicable state or city tax.

The analysis indicates that if Sam's tax rate is the same following retirement as it was when he made the contributions, both options provide the same total retirement benefit. If Sam's tax rate goes down, the pre-tax option was the right choice; if his tax rate goes up, the Roth was the right choice.

Next let's examine the outcomes following retirement of $20,000 contributions to both accounts. As we determined, the $20,000 Roth contribution decreases Sam's paycheck by $30,769 as compared to the $20,000 contribution to the pre-tax account, which decreases his paycheck by only $20,000. To formulate a sound comparison of the $20,000 maximum contribution to the Roth versus a $20,000 maximum contribution to a pre-tax account, we must consider that it costs Sam $10,769 more to contribute to the Roth. Therefore, we’ll invest the $10,769 after-taxes are paid in a side fund. The side fund benefits are combined with the pre-tax benefits and compared to the Roth benefits to formulate a sound comparison.

Simple Answer to a Very Complex Decision The decision for Sam is very easy considering the results of the analysis. Sam's retirement benefit is greater if he selects the Roth option even if his MTR decreases from 35% to 28%, and it is significantly greater if his MTR remains at 35% or it increases to 42%. The reason for this unexpected outcome is the ability to invest in various asset classes within the tax-free Roth environment. Assuming comparable risk factors on the chosen investments, it is virtually impossible for a taxable side fund to perform as well as the tax-free Roth. This strengthens the case for:

Reason # 4: The Roth option provides an opportunity to diversify future tax risk.

Prudent investing dictates that one should diversify investments in accounts or investment vehicles that are taxed differently (i.e., taxable, tax-deferred, tax-free). The Roth option provides a very attractive alternative to tax-free investing as compared to traditional tax-free investments such as tax-free bonds.

Roth Also Facilitates Prepayment of Income Tax for Estate Planning Purposes By paying income tax now on the Roth 401(k) contributions, the participant effectively prepays federal income tax on money that passes to his heirs without impacting gift or estate tax exemptions.

Roth is Solution for HCEs Limited by Test Failure (testing not applicable to 403(b))

Example 3: Same Roth Contribution Means Higher Salary Reduction It turns out that Sam works for a company that limits pre-tax contributions to $5,000 by HCEs to avoid failure of the 401(k) nondiscrimination test (HCEs age 50 or older are permitted to contribute the $5,000 catch-up contribution since it is not considered for testing). The $10,000 Roth contribution decreases Sam's paycheck by $15,385 as compared to the $10,000 contribution to the pre-tax account, which decreases his paycheck by only $10,000. Does the Roth 401(k) option offer him a better alternative?

Roth is Solution for HCEs Limited by Test Failure Even under the extreme example of a plan that limits contributions by HCEs to only $5,000 ($10,000 as illustrated if age 50 or older), Sam's retirement benefit is greater if he selects the Roth option even if his MTR decreases from 35% to 28%, and it is significantly greater if his MTR remains at 35% or increases to 42%.

Modeling software that illustrates the prospective future outcomes for choosing the Roth or pre-tax options is important to assist participants with this decision, but no analyzer or person can predict the future with certainty. Whether you believe that rates will go up or down, the results shown here prove that the Roth alternative is a sound choice for high paid individuals who wish to maximize their savings. As to a flat tax, if Steve Forbes ever does get elected, you can be sure that previously established retirement accounts will not be exempt from separate taxation rules.

Many plan sponsors and service providers have, rightfully so, elected to wait until the dust settles on the Roth 401(k)/403(b). Some feel there is too much uncertainty in the law (even though dealing with issues absent final guidance is routine for pension service providers), while others question the capability of payroll and administration systems to comply with the Roth rules. Further, no one knows how participants will react to this option. Nonetheless, I believe that HCEs will desire this option... do you want to tell them they can't have it?

Before the Roth 401(k), no plan option ever distributed both contributions and interest 100% income tax-free. This once in a lifetime opportunity starting on January 1, 2006 is a limited time offer, unless it is extended beyond its current expiration date in the year following 2010.

There is no “one size fits all” answer to the question: “Pay Uncle Sam Now or Pay Him Later?” but knowledge of the rules and contingency projections of future outcomes provide meaningful guidance for plan sponsors and participants. You don't need a crystal ball to see that the Roth 401(k)/403(b) affords significant retirement and estate planning opportunities for taxpayers of all income levels.