When is the Roth a Winner?

by Joe on April 5, 2012

Our next question is from Brian –

“The Roth is great, but the tax deduction I get on my traditional 401(k) is really nice too.

What if I have higher income? Say I’m in the 28% bracket and have $33K of pre-tax money to put into a retirement account. With a self-employed 401(k) plan I can contribute the full $33K because of the deduction. If that’s a Roth 401(k), I can only put in $17K (which is the Roth limit), pay $4760 on taxes on that money, and then have $11,240 as a profit-sharing which would get a tax deduction. (Though it’s possible I’m mistaken on the second part of that.) That’s nearly $5K *less* in the Roth account today; at 8% for 35 years that means a $70K smaller balance in the Roth when I’m in the early years of retirement.

My question is: what assumptions have to be true to make the Roth a winner?

Assume that I have a separate emergency fund and thus will never need to take advantage of the Roth early withdrawal of contributions rules.”

Excellent question, and your copy of Ed Slott’s The Retirement Savings Time Bomb has been ordered for you.

Your question as I read it, is contrasting the Solo 401(k) with its 2012 limit of $50,000 to a standard 401(k)’s $17,000 limit. Let me take a moment here to explain. $50,000? Yes. Employer contributions to a Solo 401(k) (Also called an Individual 401(k)) is “The lesser of up to 25% of the compensation* or, for 2011, $49,000; for 2012, $50,000. The dollar figure must be reduced by any employee deferrals made to the plan. Deductible as a business expense and not required every year.” So, indeed, the “employer” deposit can benefit you as you are both employer and employee in this case.

But here’s the catch – “Deductible as a business expense.” Wouldn’t that be great? A deduction as the boss, but no tax as the employee? In a large company plan offering a Roth 401(k), any matching goes into the pre-tax side of the account, i.e. the standard 401(k). This would also be the requirement for the Solo Roth 401(k), the non-Roth side to accept the pre-tax employer deposit.

I’d note that while the Solo 401(k) is a common brokerage offering, the Solo Roth 401(k) is a bit less common. I do see it offered by Vanguard, and others mentioned in the WSJ article 401(k)s for Solo Businesses.

The Roth decision gets tougher the further out in time you look. If I had a crystal ball, I’d want to know how much you saved pre-tax by retirement and the tax bracket you are in with the retirement withdrawals. Of course, I’d pay attention to your current tax bracket, 28%. When I look at the chart for Marginal Rates, I see that the 28% bracket ends at over $200K/yr taxable income (for Married Filing Joint). Even before we discuss the standard deduction and exemptions, that future you would need over $5 million pre-tax to generate $200K in taxable income. Until you are on track to have this kind of money generating income for you, I’d favor the pre-tax retirement accounts. If for whatever reason, you have a year in which your marginal rate drops, that may be the time to convert a bit of your IRA money to a Roth account. If you are not married, check out the chart and run the numbers. Keep in mind, the marginal rates change with inflation, and even if “rates go up” as we fear they may, the focus is toward the higher income levels, above $200K.

To answer directly – the Roth is a winner when good fortune leads you to realize you are on track to have savings perhaps combined with a pension so high that you’re income will be higher at retirement. Roth wins when you convert in low income years.  Last, Roth wins when your AGI is too high to deduct the traditional IRA and the ability to put away the $5000 into a Roth is a simple decision.

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