Thursday, May 17, 2012

To Roth or Not to Roth, That is the Question

We often get the question:  “I have the option of making Roth (post tax) contributions to my 401k – should I do that?  How should I decide?”

Without getting into all the minutiae of current tax rates vs. future tax rates, tax inclusive vs. tax exclusive and marginal rates vs. effective rates, the easy answer is: do some of each.

You can use the tax savings generated by the pre tax contribution to pay the taxes on the post tax contribution – and, you can arrange the mix of each so that it is tax neutral.

If tax neutrality is your objective, then the actual mix of pre and post tax contributions varies a little depending on your tax bracket.  To keep it simple, we’ll show one example using the 28% tax bracket:

Maximum 401k contribution       $17,000

Pre tax                                     $  9,884 saves $2,768 in taxes

Post tax                                    $  7,116 costs  $2,768 in taxes

Total contribution                      $17,000

Net tax cost                              $-0-

Net contribution cost                 $17,000

What if you don’t have a Roth option in your 401k?  You can use this same logic to fund a Roth IRA – the pre-tax contribution to the 401k can offset the taxes you pay to make the Roth IRA contribution.  The math is the same.

At retirement when you withdraw your funds:
·        the pre tax funds plus related earnings will be taxable
·        the post tax funds plus related earnings will be tax free
·        ALL employer matching contributions plus related earnings will be taxable (regardless if the match is to pre tax or post tax contributions)

No comments: