Ten Steps to Reforming Baby Boomer Retirement

Studies | Retirement

No. 283
Thursday, March 23, 2006
by John C. Goodman, Devon Herrick, Matt Moore


Step 6. Using the Roth Method of Taxation

Traditional retirement savings vehicles, such as 401(k)s and IRAs, are tax-deferred accounts. They allow people to invest pretax dollars, but taxes must be paid on the investment and accumulated earnings at the time of withdrawal. By contrast, deposits to Roth IRAs are made with after-tax dollars and withdrawals are tax-free.

Table I - Which Is Better%3A Regular 401(k) or Roth 401(k)%3F

"Roth IRAs allow workers to withdrawal funds tax-free."

Both accounts grow tax-free and both allow withdrawals at age 59½ without penalty. However, there are other differences. People with ordinary IRAs must stop making deposits when they reach age 70 and begin making minimum withdrawals. People with Roth IRAs can contribute at any age and are not required to withdraw funds at any time. But there are income restrictions on who can participate: Taxpayers who file as a single with an adjusted gross income more than $110,000 cannot contribute to a Roth IRA, and cannot make the full contribution if their adjusted gross income is between $95,000 and $110,000. Taxpayers who are married filing jointly cannot contribute to a Roth IRA if their adjusted gross income is greater than $160,000, and can only make a partial contribution if their income is between $150,000 and $160,000.

New in 2006: Roth 401(k)s. Currently, 401(k) plans are taxed like ordinary IRAs. Contributions are made with pretax dollars and people pay income taxes on the contributions plus earnings when funds are withdrawn. Starting this year, however, employers can offer Roth 401(k)s. Workers can contribute after-tax dollars to an employer-sponsored Roth 401(k) plan, and the money will grow tax-free and eventually be withdrawn tax-free.

The new plan is similar to a Roth IRA, in that it lets savers contribute after-tax money that grows tax-free. But Roth 401(k)s differ from Roth IRAs in a few key areas: Roth 401(k)s have no income limits for participation, and the same higher contribution levels and penalties for withdrawals before age 59½ as traditional 401(k)s.

"A Roth 401(k) would lower the tax burden for some workers."

Who Benefits from Roth Taxation? Which is better, a regular account or a Roth account? The answer depends on a worker's marginal tax rate during the working years compared to the tax rate faced during retirement. In general, one wants to pay taxes when the tax rate is lowest. The traditional assumption has been that people will be in a lower tax bracket after they retire, so investing pretax dollars and paying taxes when the money is withdrawn means they will pay less taxes over their lifetime. But there are two reasons this assumption may to be wrong — especially for many young people.

Figure VII - Marginal Tax Rates for a Couple Retiring 30 Years from Now

First, as we have seen, many moderate-income families will be pushed by the Social Security benefits tax into higher tax brackets after they retire than when they were working. Thus, paying taxes on accumulated savings after retirement may cost a family more over its lifetime.33 Second, there are massive public policy changes on the horizon. As the baby boomers age and retire, the costs to society of providing Social Security, Medicare and Medicaid benefits will most likely lead to higher taxes across the board. So it is probably a safe bet that tax rates will be higher in the future.34

NCPA scholars used a financial planning model developed by economist Laurence Kotlikoff to determine whether a Roth account or a regular account is better for workers at different income levels.35 Table I examines the outcomes at different income levels for one-child families in which both spouses work and are age 36. As Table I shows:

  • A family earning $75,000 will face an 18 percent marginal tax rate while working and a 24 percent tax rate in retirement; thus, they are better off with a Roth.
  • Families earning $35,000 and $125,000 face higher marginal tax rates while working than when retired; thus, they are better off with a traditional IRA.

To understand why this is the case, see Figure VII . It illustrates the marginal tax rates for a two-earner couple retiring 30 years from now. Because of the Social Security benefits tax and the complexity of the U.S. Tax Code, a worker's marginal tax rate can range from 28 percent to 46 percent before the worker ever enters the 28 percent tax bracket.

"The Social Security benefits tax raises marginal tax rates on retirement income"

Needed: Parity for Roth IRAs. As noted, contribution levels are different for regular IRAs and 401(k)s. They are also different for Roth IRAs and Roth 401(k)s. The unequal contribution levels are unfair to people who do not have access to employer-sponsored plans. Why should workers fortunate enough to have access to a 401(k) benefit from tax-preferred treatment of up to $15,000, while those without a 401(k) can only contribute one-third of that amount? Congress should level the playing field.


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