Vanguard Studies Tax Implications of the Roth401k

Since Roth contributions are made after-tax and the investment earnings on these contributions are not taxed, the study points out that participants using the Roth feature essentially “pre-pay” their retirement income taxes. Those who choose the feature can boost their after-tax savings in retirement by 11% to 33%, depending on their tax bracket. They may also realize four percent to 13% savings on taxes in retirement.

The study says participants who will benefit the most from the Roth feature are those who are better prepared for retirement (and won’t depend mostly on Social Security for their income), participants who are contributing at the maximum (402(g)) limit on deferrals, and those in lower (10 – 15%) tax brackets.

In addition, the study says, participants on track to replace a higher percentage of their working income in retirement would do well to make both pre- and post-tax deferrals, since the higher the replacement ratio, the more likely Roth contributions will yield the same or greater tax benefits in retirement.

Those participants whose tax rate decreases after retirement will likely incur more tax costs and not receive the tax diversification benefits of the Roth feature. However, the study points out that overall savings on an after-tax basis will mean they are likely to be just as well off anyway.

A recent PSCA survey found that 17.4% of plan sponsors will offer the Roth 401(k) feature when it is available in 2006 (See Nearly 20% of Employers to Add a Roth K Feature ).

The Vanguard study is here .