August 1, 2010

Roth Is Wrong--for Some People

I have been worried for some time that plan sponsors and participants do not understand the consequences of Roth deferrals. I am concerned that many plan sponsors do not educate participants properly and that many uninformed participants are making Roth deferrals.

That is not to say that Roth is wrong for everyone. Instead, Roth deferrals are right for some participants, but not for others. That leads to my second point, which is that plan sponsors and providers should be giving participants the information they need to make informed decisions. I recently wrote an e-mail to a client describing my concerns. This edited version does not discuss all of the Roth issues, but it highlights my concerns.

The proper way to evaluate Roth versus regular deferrals is to estimate the point at which the marginal tax rate at the time of the deferral is the same as the marginal rate on the distributions. In other words, you want to pay taxes at the lowest rate, comparing actual taxes at the time of deferral to estimated taxes at the time of distribution.

A mistake that people make when comparing regular deferrals to Roth deferrals is that they assume that the retirement benefits of participants will be distributed and taxed as a lump sum at retirement. However, most retirees roll over to IRAs. So, the real question is: How much will participants take out—and be taxed on—each year? Obviously, that is an unknown, but most experts recommend that participants take out no more than 4% to 5% per year. On the other hand, if a participant buys a joint-and-survivor annuity with his spouse, the payments will be about 6% per year.

Let’s take a look at those two scenarios. First, for the typical husband and wife filing a joint return, they can earn about $20,000 a year without paying any taxes. In other words, the first $20,000 that they receive from a taxable IRA will be tax-free.

For a withdrawal rate of 5%, a partic­ipant should have at least $400,000 in a non-Roth, taxable account—to take advantage of the tax-free $20,000; it is better than Roth—tax deductible when deferred and tax-free when distributed. Furthermore, the first dollars over that amount will be taxed at the lowest tax rates, lower than the top marginal tax rates the participant paid while employed—and, therefore, lower than the taxes the participant would have paid if he had made a Roth contribution.

On the other hand, if a participant is going to buy a joint-and-survivor annuity, the participant will receive about 6% per year. So, the numbers drop a little. For example, a $350,000 account would buy an annuity that pays about $21,000 per year.

So, my thinking is that participants should have at least $400,000 to $500,000 in taxable account balances (projected at retirement) before they start making Roth deferrals. Moreover, as a practical matter, how many partic­ipants are going to end up with account balances larger than that?

On the other hand, there is a greater likelihood that high-paid people can benefit from Roth. Even there, though, the definition of “high paid” needs to be thought out. For example, if a person is making $250,000 today and wants to retire on $100,000 per year (which, using a 5% withdrawal rate, would be the equivalent of $2,000,000 of IRAs, 401(k) account balances, pension plans, and other income-producing assets), there is a question of how much of the $100,000 will be taxable. The first $20,000-plus per year will be tax free. Some of the distributions above that will be taxed at such low brackets that the participant would have benefitted by deducting the deferrals. Then, there is the question of how much of the remainder will be offset by tax deductions­. For example, will the participant have mortgage interest deductions? So, even for the highly paid, there is a need to balance regular and Roth deferrals to achieve maximum tax efficiency.

This is a complicated analysis, but the general message is that, unless a participant has calculated, using reasonable assumptions that Roth deferrals produce superior results, the participant should probably make regular deferrals. Plan sponsors and providers need to give participants the information and tools to make those calculations.

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