The Wall Street Journal has a good article in today’s paper (subscriber link) on the merits of Roth 401(k)’s:
Thanks to the new pension law, Roth 401(k) plans are no longer slated to disappear in 2011 — and that means a lot more companies will consider offering these plans.
Want a shot at tax-free investment growth? Here’s why you should phone up human resources and put in a request for the Roth 401(k).[...]
[I]magine you are eligible to stash $15,000 in your employer’s 401(k), your marginal federal and state tax bracket is a combined 35%, and you also expect to be paying taxes at 35% when you tap the account 20 years from now.
Given your 35% tax rate, you would need $23,077 in pretax income to contribute $15,000 to the Roth. Over the next 20 years, let’s assume this $15,000 triples in value to $45,000. You could then cash out this $45,000 tax-free.
What if you plunked your $15,000 in a regular 401(k) instead? Assuming you bought the same investments, your account would also be worth $45,000 after 20 years. Trouble is, when you cash out, you would owe 35% in taxes, or $15,750, leaving you with $29,250.
“Unfair example,” you cry. “With the Roth, you really contributed $23,077, or $8,077 more.”
True enough. To make the comparison fair, suppose you invested $15,000 in a regular 401(k) and then looked to sock away an additional $8,077 in a regular taxable account. You would have to pay 35% in taxes on this $8,077 of income, leaving you with $5,250 to invest. If this $5,250 also tripled in value, you would have $15,750 after 20 years, enough to cover the tax bill on the regular 401(k).
All even? Not quite. The problem: You will owe taxes on the investment growth enjoyed by the taxable account’s $5,250, so the money won’t fully cover the tax bill on the regular 401(k) — and thus the Roth wins.
There are other advantages to Roth accounts discussed in the article. However, the above was one of the better descriptions of the nuances in the tax differential between regular retirement accounts and Roth accounts.
However, they didn’t discuss one of the reasons I find Roth accounts attractive. The idea of tax-deferral works only as long as general levels of taxation remain relatively consistent.
Looking at the unfunded obligations in the government’s future…it’s difficult to imagine that tax levels won’t be greater in the future than they are today. If that fear proves correct, wouldn’t it be better to pay taxes now, when taxation is low, rather than in the future, when higher rates prevail?