Last Updated Oct 29, 2010 10:10 AM EDT
Now let's do the math to see how a Roth 401k conversion can increase your effective retirement savings. Let's look at an example, where I'll make some simple assumptions:
- You have $100,000 in your traditional 401k plan.
- Your combined marginal federal and state income tax bracket is currently 35 percent.
- Your 401k accounts earn 5 percent per year.
- You have $35,000 in liquid savings outside your 401k plan, also earning 5 percent per year and taxed as ordinary income. As discussed in my prior post, most likely you'll be paying income taxes on the conversion to the Roth 401k with money that's outside your traditional 401k plan. For the purpose of making a proper comparison, I'm assuming this $35,000 is the outside source of money to pay these taxes.
- You decide to retire in 10 years, withdraw your 401k accounts, and pay income taxes at that time. At that time, your combined marginal income tax rate is still 35 percent.
Results if you keep your retirement savings in the traditional 401k
At 5 percent annual investment returns, your $100,000 will grow to $162,889 (if you're mathematically inclined, that's $100,000 times 1.05 **10). You'll pay 35 percent of that amount in taxes -- $57,011 - leaving an after-tax amount of $105,878.
Now let's look at your liquid savings outside the 401k plan. Since you aren't using it to pay income taxes on a Roth conversion, I'm assuming this amount remains invested until retirement. You'll be taxed on investment income each year, so your 5 percent rate of return is really 3.25 percent each year, after you pay income taxes on your earnings. At that rate, your $35,000 will grow to $48,191 in 10 years. Since you've already paid taxes throughout the 10 years, you have all this money to spend.
The total amount of money that you can spend at retirement is $154,069 -- the sum of $105,878 and $48,191.
Results if you convert to the Roth 401k
You'll pay 35 percent income taxes today on $100,000 -- $35,000 -- so the money that is currently invested outside the plan is gone. The $100,000 that you have in your 401k today remains invested inside the 401k plan, and will grow to $162,889, as shown above. Since Roth accounts aren't taxed upon withdrawal, you'll have all this money to spend.
In this example, the Roth 401k conversion increases your retirement savings by $8,820 (that's $162,889 minus $154,069).
Of course, you might get different results, depending on your assumptions regarding your marginal tax rates now and in retirement, your expected return on assets, and whether your investment income is taxed at ordinary rates or capital gains rates.
The above example also shows that a Roth 401k conversion may not make sense if you think you'll be in a lower tax bracket in retirement. But it could make a lot of sense if you think you'll be in a higher tax bracket in retirement. For a discussion on this topic, see my prior post Are Roth IRAs and 401k Are Better Because Tax Rates Will Increase? Don't Count on It.
The time you spend analyzing whether a Roth conversion is good for you will be time well-spent, as most of us need to make every dollar count in retirement!