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Roths Worth Another Look

Terry Savage

We've all been taught the importance of pretax savings growing tax-deferred in a traditional IRA or 401(k) plan. The idea is to pay the taxes after retirement, when you'll surely be in a lower tax bracket.

But maybe it's time to rethink that advice, especially if you're just beginning your retirement savings.

A Roth IRA after-tax contribution is starting to look more and more attractive, especially if you're in your 20s and have plenty of time to grow your money tax-free. And now that the newly passed Pension Protection Act has encouraged companies to offer an after-tax Roth 401(k) option, it's more likely that you'll be faced with the pretax or after-tax decision.

It sounds like heresy, but many people -- lower-income as well as higher-income workers -- might be far better off paying taxes right now and making an after-tax contribution to this new type of Roth 401(k) plan. Companies aren't required to offer the Roth 401(k) alternative, but they may feel a lot of pressure to include the option when they realize how attractive it is to lower-paid and younger workers.

Getting Tax Perspective

The current income tax brackets are relatively low. If you're single and have income under roughly $31,000, you're paying only 15% on your last dollar earned. Historically speaking, that's a bargain compared to 1963, when the top personal tax rate was over 91% and the lowest rate was 20%!

Policymakers have ample historical evidence that lower tax rates produce more revenue -- but given the current budget deficits, it will be hard to avoid raising income-tax rates in the future.

Economist Lawrence Kotlikoff, writing in the latest bulletin of the Federal Reserve Bank of St. Louis, demonstrates the likelihood for higher taxes in the future in a study titled "Is the United States Bankrupt?" He calculates that the U.S. has an unfunded debt liability that already exceeds $65 trillion. Among the conclusions: 18-year-old workers today could face marginal net tax rates as high as 80%, when you consider all taxes!

"The fiscal irresponsibility of both political parties has ominous implications for our children and grandchildren. Leaving our $65.9 trillion bill for today's and tomorrow's children to pay will roughly double their average lifetime net tax rates," Kotlikoff concludes in this report.

Given the likelihood of future tax-rate increases, plus the hope that you'll be earning more as your career expands, you should consider putting at least a significant portion of your money in an after-tax retirement plan to get the promised tax-free gains down the road.

The Roth Opportunities

Roth IRAs allow workers (and nonworking spouses) to contribute $4,000 ($5,000 if 50 or older), but only if your modified adjusted gross income is under $95,000 on a single return or $150,000 on a joint return. (With income slightly above those limits, a partial contribution can be made.) That's the easiest way to get tax-free growth working for you. And beginning in 2010, conversions to Roth IRAs from regular 401(k)s won't have income limitations.

The Roth 401(k) option, which doesn't have an income ceiling, was offered for the first time in January. But because of uncertainties about the future of this tax promise (prior to the Pension Act's passage it was scheduled to expire in a few years) and costs associated with developing systems to track after-tax contributions, few companies offered it. Now, with permanence assured, it will be popping up on more corporate-benefit menus.

If your employer decides to offer the Roth 401(k) option, who should consider the opportunity?

Which Investments Where?

That still leaves some unanswered questions for those who have both types of plans. Because traditional after-tax plan withdrawals all are taxed as ordinary income, you lose the benefits of the lower capital gains tax rates, and get no tax breaks for losses. Many say that's an argument for putting income-earning investments inside your traditional retirement plans and taking capital risks outside your retirement accounts.

But the real benefit of all of these retirement plans is the tax-deferred growth you can amass over the years. And getting growth requires a commitment to a diversified equity portfolio. I'd argue that it's more important to get the growth over the long run than to worry about the capital gains taxes vs. ordinary income.

So don't get hung up on which type of investment goes into which account. Just diversify appropriately across all your retirement accounts, and base your asset allocation on your age and goals, rather than the pretax or after-tax component.

I never heard anyone complain about retiring with too much money! And now you have a chance to have both a lot of money and no taxes on all that growth when you retire. It's an opportunity you can't afford to miss. And that's The Savage Truth.