Will you be in a higher or lower tax bracket when you retire? This is the typical question asked of employees when they are faced with the decision to choose between a pre-tax or Roth 401(k) option, sponsored by their employer.
For a younger worker just starting their career, the answer is a no brainer, since they are most likely coming in at the bottom of the pay scale for their field and will have a very high probability of making more later in their career, which will lead to a higher tax bracket in the future.
For employees on the cusp of retirement, their last few years of earned income should be higher than what they will be planning to live off of in retirement, so pre-retirees are usually looking forward to a drop in their income tax bracket. But what about the bulk of your employees that fall in the middle?
Variables make decision-making difficult
The reality is that no one truly knows what will happen to our own tax situation in the future. We can speculate that tax rates in general could go up due to our Federal deficit, or that we are going to be thrifty in retirement and not need to take much in the way of taxable distributions, but these are really just conjectures based on opinion, not facts.
There are many variables that might potentially impact what we may think of as a truth today. What might happen to the advantage of the Roth tax-free growth if we move to a VAT, or value-added tax? The VAT would be a consumption tax on purchases, instead of (or in addition to) an income tax. The VAT is currently being used in every member state of the European Union, as well as Japan and Australia. A consumption tax could be on the horizon for the U.S. too, since Cain’s 9/9/9 Plan incorporated the concept of a 9 percent consumption tax.
Since there really is no easy answer to the question of “to Roth or not,” I like to look at the Roth option as a way to further diversify my retirement account, so not only am I allocating among different investment classes, I’m also able to allocate among two tax classes. Instead of having to choose either the Roth OR the pre-tax option, I like to look at a proportionate amount in each based on a participant’s current tax bracket, and any breakpoints they may be near for Federal deductions or credits.
Misconceptions over the Roth option
A newly hired employee right out of college at first glance might be an excellent candidate for the Roth due to their age, but if their income is on the borderline of qualifying for a deduction on their student loan interest ($75,000 AGI for single taxpayers in 2011), then the pre-tax option may be a better fit to reduce their taxable income below the threshold. If their gross income is $76,000 with a desire to contribute 10% to the 401(k), then a 2 percent pre-tax and an 8 percent Roth allocation would be better than all 10 percent towards the Roth, so the employee would be able to qualify for the student loan deduction.
With the Roth decision being many shades of gray, it’s no wonder that only 16.1 percent of eligible participants even choose to utilize the Roth 401(k) option, according to the PSCA 54th Annual Survey of Profit Sharing and 401(k) Plans. There is still a lot of confusion in the workforce, not only about who might benefit from the Roth, but a common misconception that I hear frequently from higher income workers is that they think the Roth IRA income limitations also apply to the Roth 401(k), which is not correct.
With over 45 percent of employers now offering the Roth option, it is more important than ever to provide worksite retirement education, and since the Roth’s advantages are based on each employee’s individual tax situation, offering one on one retirement planning consultations may be the best route to take.
This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education.