Most analyses of the tax benefits of Roth contributions compare the results of a tax-deferred contribution to a plan versus the contribution of the same amount as a Roth contribution, less the tax payment required on the contribution. This results in the conclusion that there is no difference in the resulting savings of the participant if the tax rate at the time of the contribution is the same as the tax rate at the time the participant begins to take distributions. If the latter tax rate is higher, then the participant has more savings with Roth contributions. Conversely, the tax-deferred contributions result in greater savings if the tax rate at the time of distribution is lower.
The July/August 2008 issue of the Aon Forum looks at this issue differently. What if the participant has sufficient resources to maximize the contributions to the plan and pay the taxes on the Roth contributions from other funds? For example, a participant is permitted to make deferrals of up to $15,500 in 2008. If that deferral amount is a Roth contribution, then the participant must pay an additional $8,346 in federal taxes on the sum of the deferral and the tax amount, assuming a 35 percent tax rate. If the deferral is a traditional tax-deferred 401(k) contribution, the participant will have an additional $5,425 of income tax savings to invest personally.
In the tax-deferred scenario, if sufficient time passes for the deferral and the taxable investment to double, the plan account will be $31,000 and the outside investment will be $10,850. Applying a 35 percent tax rate to the plan account and a 15 percent capital gains rate to the taxable account leaves a net after-tax value of $30,186. If the deferral was a Roth contribution, however, the plan account balance after the same passage of time would be a tax-free $31,000. Thus, the Roth contribution has resulted in larger savings even assuming the same marginal tax rate at the time of contribution and distribution.
The article’s authors acknowledge that the $814 increase under the Roth scenario seems “relatively modest,” but they point out that they used the most favorable assumptions regarding the growth of the taxable account in the tax-deferred 401(k) deferral scenario. More realistic assumptions would include the payment of some tax each year on the income from the taxable account, which may be taxed at higher rates than the 15 percent long-term capital gains rate. State taxes could cause even more erosion in the appreciation of the taxable account in that scenario. The authors suggest that over a significant period of time, use of Roth contributions in this manner could result in very significant increases in the participant’s savings.
They also note that catch-up contributions are available when the participant reaches age 50. If the participant makes a Roth contribution of $20,500, it is the equivalent of a pre-tax deferral of $31,538, using a 35 percent tax rate. This makes the eventual savings growth using Roth contributions even more significant.
Greg Matthews, Matthews Benefit Group, Inc., St. Petersburg, Florida