TO ROTH OR NOT?
September 3, 2008
In 2006, the Roth 401(k) plan was introduced as an alternative to regular 401(k)s. Whereas contributions to regular 401(k)s are made with pretax dollars, Roth 401(k) contributions are made with after-tax dollars. When retirees withdraw their funds from regular 401(k)s, the contributions and accumulated earnings are taxable. But since taxes have already been paid on Roth contributions, all of the funds in the Roth account can be withdrawn tax-free. Which type of 401(k) is better?
According to Laurence J. Kotlikoff, a senior fellow with the National Center for Policy Analysis, and a professor of economics at Boston University, one advantage of regular 401(k)s over Roth 401(k)s is the potential benefit of employer matching funds since employers are not permitted to make matching contributions to Roth 401(k)s. However, likely future tax increases to pay the burgeoning cost of elderly entitlements favor Roths since Roth withdrawals are tax free. Thus:
- A 3 percent contribution to a regular 401(k) matched by a 3 percent employer contribution would be better for all households at all ages and income levels than the total equivalent contribution from the employee's own income to a Roth 401(k).
- However, if a firm does not offer matching contributions, and there is a 30 percent tax increase in the future, the Roth is preferable in most cases.
For example, faced with a 30 percent income tax hike on their retirement income, a 60-year-old couple earning $100,000 a year and receiving no employer match on regular 401(k) contributions would enjoy an 80 percent greater increase in their living standard by contributing to a Roth 401(k) rather than a regular 401(k).
Source: Laurence J. Kotlikoff, Ben Marx and David S. Rapson, "To Roth or Not?" National Center for Policy, Policy Report No. 314, September 2, 2008.
Browse more articles on Economic Issues