Should taxpayers invest in the new Roth 401(k)?

The basics of Roth 401(k)s were discussed elsewhere (see Oleasz, Tax Clinic, "New for 2006: Roth 401(k)s," p. 723, this issue). This item discusses the type of taxpayer that will benefit from investing in a Roth 401(k).

Limited Resources

The first kind of investor is one with only limited resources. These investors have only a certain amount that they can contribute to a Sec. 401(k) plan. If they contribute to a Roth 401(k) instead, the contribution is made on a post-tax basis.

Example 1: Employee Z has determined that he can invest $10,000 in a traditional Sec. 401(k) plan. His marginal tax rate is 25%; thus, the amount actually available to contribute to a Roth 401(k) instead is $7,500. Z makes contributions for 20 years, with 8% growth per year.

At the end of 20 years, Z's traditional Sec. 401(k) would have accumulated approximately $476,000, while the Roth 401(k) balance would be only approximately $357,000. However, this does not provide an accurate picture of the accounts' real values. If Z takes distributions over 20 years, with a continuing 8% return, his annual pre-tax distribution will be approximately $46,610 from a traditional 401(k). A Roth 401(k) will provide an annual tax-flee distribution of approximately $34,960; see Sec. 402A(d)(1).The exhibit below indicates the net amount received from a traditional Sec. 401(k) at various tax rates.

The exhibit demonstrates that when the marginal tax rate during retirement is less than the rate when the contributions were made, a traditional Sec. 401(k) is the preferred choice. Conversely, when the marginal tax rate is higher during retirement, the Roth 401(k) provides more cash annually.

Other considerations: The complexity for Z continues, however; there are situations in which Z may want to invest in a Roth 401(k), even when the calculation indicates that this is not beneficial:

* While Roth 401(k)s have the same minimum distribution requirements as do traditional Sec. 401(k)s, the former can be rolled over into a Roth IRA (see Sec. 402A(c)(3)(A) (ii)), which has no such requirement. Thus, the account can continue to accumulate tax free, even for a period after the investor's death. This alternative provides for interesting estate planning opportunities.

* For an investor who, because of the availability of other resources, will not need required Sec. 401(k) distributions, the ability to roll over a Roth 401(k) into a Roth IRA may be beneficial.

Maximum Contribution

The second type of investor is an employee who can afford to contribute the maximum amount to a Sec. 401(k) plan, regardless of the tax cost.

Example 2: Y contributes $15,000 per year to a Sec. 401(k) plan for 20 years. The account accumulates approximately $714,000, resulting in an annual distribution of approximately $60,915.

The number of variables that determines which investment is most beneficial is truly staggering:

* Y's tax rate when contributions are made.

* Y's tax rate when distributions are made.

* The return on investments made in lieu of paying taxes, if a traditional Sec. 401(k) is chosen;

* The tax to be paid annually (e.g., on short- and long-term capital gains, and qualified and unqualified dividends) on investments made in lieu of paying taxes.

* Whether, in selecting a Roth 401(k), the distributions will be rolled over to a Roth IRA to continue tax-free accumulation, or whether they will be needed in retirement.

Business owners: Many tax advisers have recommended that the employed children of business owners invest their earnings in a Roth IRA. The Roth 401(k) presents a new option.

Example 3: X owns a closely held business. She hires her 15-year-old daughter, W, to work for the business during vacations, on occasional weekends and after school. W receives $15,000 in wages and pays payroll, Federal and state income taxes of approximately $2,940. She contributes $10,000 to a Roth 401(k).The business's payroll taxes on W's income are approximately $1,150.The business is successful; it is in the 35% tax bracket. It have a combined tax savings of approximately $5,700 from paying W. Thus, the net tax savings is approximately $1,610 ($5,700 - ($2,940 + $1,150)).The tax savings are higher than the total taxes paid; further, W will later be able to take tax-free distributions from her Roth 401(k) that have grown tax free.

Flexibility

The Roth 401(k) presents a powerful savings alternative. Business owners should carefully weigh whether they should make this alternative available to their employees. Businesses that choose to do so should ask a tax or personal financial adviser to explain the options to their employees. Employees who have the choice of a traditional Sec. 401(k) or a Roth 401(k) should consult their own tax planners for assistance.

Exhibit: Net Sec. 401(k) distribution
at various marginal tax rates

Marginal tax rate  Net amount received
         0%              $46,610
        10%              $41,949
        15%              $39,619
        25%              $34,958
        35%              $30,297

FROM MICHAEL D. KOPPEL, CPA, PFS, GRAY, GRAY & GRAY, LLP, WESTWOOD, MA