The Roth 401(k) is here to stay. The Pension Protection Act of 2006 (PPA) makes permanent pension and IRA provisions established by EGTRRA that were due to expire at the end of 2010. Now, your clients need your advice on whether they are better off contributing to a traditional 401(k) plan or the new Roth 401(k). The answer, of course, is it depends (what do you expect from a lawyer). In most circumstances, however, the Roth 401(k) will be the better choice.

Please note, the tax treatment for the employer’s contribution to an employee’s 401(k) has not changed. The question for employees of companies that offer a Roth 401(k) is whether they want their deferral contribution treated as a Roth 401(k), a traditional 401(k), or a combination of the two.

Broadly speaking, the variables that factor into the decision to contribute to a traditional 401(k) vs. a Roth 401(k) are similar to the variables you would evaluate if your client were trying to decide whether to contribute to a fully deductible traditional IRA or a Roth IRA. A key variable is the taxpayer’s current marginal income tax rate vs. the taxpayer’s expected marginal tax rate when distributions are being taken.

• If your tax bracket in retirement stays the same as when you contributed to the plan, you will be better with the Roth 401(k), as shown in the following graph.
  

The graph reflects the greatest benefit i.e., when maximum allowable contributions are made. If for example, your client is 50 or older and he can afford it, he can make a $20,000 401(k) contribution. If he contributes the $20,000 to the Roth 401(k), he is actually making a $20,000 retirement plan contribution. If he makes a $20,000 contribution to a traditional 401(k), he is really only “saving” $20,000 minus the tax savings on his contribution.

• If your tax bracket in retirement is higher than when you contributed to the plan, you will be much better off with a Roth 401(k).  
• If your tax bracket in retirement is lower than your tax bracket during your working years the picture is not as clear, but surprisingly, if the long-term plan is to keep the money in the tax-free Roth environment, possibly leaving it to heirs, the Roth is the preferred vehicle.

Effects of Slightly Lower Tax Rates in Retirement

How can the Roth become better with lower taxes in retirement, for example dropping from the 35% tax bracket to the 25% tax bracket? The answer is that it is still advantageous in the long run. The extra 10% tax savings you miss on the traditional 401(k) is eventually overcome.

Effects of Extremely Lower Tax Brackets in Retirement

The picture of the Roth is not all golden. When there is a significant drop in an individual’s post-working marginal tax rate, say for example dropping from the 35% bracket to the 15% bracket the traditional 401(k) plan is significantly better. If we extended a projection through age 96, the Roth would become better, so it could conceivably benefit your heirs—but that assumes no funds are spent. Spending would diminish the possibility of breaking even.

The bottom line is that in order to get the tax advantages from the Roth, you should be sure that you will have a tax rate in retirement that is not too much less than while working. Otherwise, the tax deduction from traditional 401(k) contributions may be too good to pass up. My rule of thumb, use the Roth 401(k) unless you will either have a 15% or more drop in your income tax rate or your investment time horizon is quite short.

Please note all the analysis of this article applies to the question of using the traditional 403(b) versus the Roth 403(b).

A full quantitative analysis is available as complimentary free report with the purchase of Retire Secure!(Wiley 2006).

James Lange is a tax attorney and CPA with a thriving retirement and estate planning practice in Pittsburgh, Pennsylvania.  He focuses on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, will and trust preparation, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, and his articles are frequently published in Financial Planning, Kiplinger's Retirement Report and The Tax Adviser.