When it comes to saving for his own retirement, certified financial planner Barry Picker takes advantage of a tax strategy ignored by most Americans.
Each year, he stashes some of his retirement savings in a Roth 401(k), rather than putting all his savings into a traditional 401(k).
Although that means that he misses out on the immediate tax break that comes from contributing to a traditional 401(k), Mr. Picker has something else in mind: a less taxing retirement.
By paying taxes now, he won't have to worry about paying taxes when he withdraws money from his Roth 401(k) later.
Money withdrawn from a traditional 401(k), of course, will be taxed as ordinary income.
The big question with which investors have to grapple, of course, is why they should pay taxes out of pocket now instead of later, especially when there is no way to know where tax rates will be in the future.
“It's a compromise,” said Mr. Picker, who also is a certified public accountant.
“I am giving up some control over managing my tax bracket today for being able to manage it in retirement,” he said. “That's going to be valuable to me later.”
ENTITLEMENTS
Although Mr. Picker is thinking about keeping his taxes down in retirement, a Roth 401(k) also provides more flexibility when it comes to managing income, and has some less obvious payoffs, as well.
A traditional 401(k) requires individuals to begin taking distributions in the year they turn 701/2 — or if later, the year they retire. They pay taxes on that income.
With the Roth 401(k), there is no required minimum distribution if individuals roll the Roth 401(k) into a Roth individual retirement account. That means individuals can choose to leave their funds invested and reduce their gross income.
Regardless of what happens to tax rates, if individuals have to take a distribution from a traditional 401(k), that can bump them into a higher marginal tax bracket, as well as reduce the net value of their Social Security benefit and increase their Medicare costs, said Maria Bruno, a senior investment analyst at The Vanguard Group Inc.'s Investment Counseling and Research group.
Consider this: For a married couple filing a joint tax return this year, up to half their Social Security benefit will be taxed if the sum of their adjusted gross income plus half their Social Security payout and any nontaxable interest income is between $32,000 and $44,000.
If their adjusted gross income rises above $44,000, up to 85% of the Social Security benefit becomes taxable. The distribution requirements of a traditional 401(k) could push their income over the edge.
If it is in a Roth 401(k), it doesn't need to.
Although the Roth 401(k)'s effect on Social Security benefits isn't a big concern for most people, given the low income thresholds, leaving one's money in a Roth 401(k) can have a more significant impact on Medicare premiums during retirement.
This year, the standard monthly premium for Medicare Part B, which covers outpatient doctor and medical services and equipment, is $99.90. If a couple's joint modified adjusted gross income is above $170,000, the per-person monthly premium can rise by $40, to $220.
The highest premiums go to couples with a joint income above $428,000 and individuals with income of $214,000. For those with joint income above $170,000 who are enrolled in Medicare Part D, which covers expenses for prescription medications, there is an additional per-person monthly premium ranging from $11.60 to $66.40.STILL NOT CONVINCED
Despite the benefits, few people are switching from traditional 401(k) plans to Roth 401(k) plans. One reason is that Roth 401(k) plans still are a relatively new option (since 2006) in employer retirement plans, and only about 40% of 401(k) plans offer a Roth option.
Among those that do offer a Roth 401(k), fewer than 10% of employees are choosing them, according to a study by Vanguard.
Many people think that the Roth 401(k) is for younger workers who have yet to hit their peak earnings (and marginal tax brackets). For them, the logic goes, losing out on the upfront tax break isn't such a big deal.
Something to keep in mind for those who do opt for a Roth 401(k) is not to rush to convert an existing traditional 401(k) to a Roth. If that happens, an individual will pay taxes now on the conversion.
A better strategy may be to shift new 401(k) contributions to the Roth and start building savings that will be tax-free when the individual retires.
Also, money saved in a Roth 401(k) can be withdrawn tax-free once the account is at least five years old and an individual has made it to the Internal Revenue Service's awkward 591/2 age threshold for penalty-free retirement withdrawals.
If an individual leaves his or her job at 55 or later, he or she can take distributions from the Roth 401(k) with no penalty, assuming that the account is at least five years old.
Once an individual invests in a Roth 401(k), there is no do-over provision; those funds can't be converted to a traditional 401(k), noted Ed Slott, a CPA and an IRA distribution expert.
That limitation doesn't dim his enthusiasm for the Roth.
“You lose your upfront tax break today, but you can't beat a zero tax rate in the future,” Mr. Slott said.
