Why a Roth 401(k) may be bad for your wealth

This post comes from partner blog The Dough Roller.

Let's get right to the point: Saving for retirement in a Roth 401(k) likely will leave you with less money in retirement than if you had invested in a traditional 401(k).

There are some exceptions to this rule. For example, a Roth 401(k) may be the right choice if you make more than $1 million a year or if you make so little that you pay no income tax or very little income tax. But for the majority of us, the Roth 401(k) is better left alone. Here's why.

Roth 401(k) basics

A Roth 401(k) is a retirement plan set up by employers that allows employees to contribute to their retirement. Unlike a traditional 401(k), which is tax-deferred, money invested in a 401(k) Roth account is included in an employee's taxable income. For example, if an employee is in the 25% federal tax bracket and pays 5% in state income tax, he or she would have to make $14,285 in gross income to invest $10,000 in a Roth 401(k).

Here's the math: $14,285 x 30% = $4,285 in taxes. $14,285 - $4,285 = $10,000.

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The benefit of a Roth 401(k) is that your investments grow tax-free. If, by retirement, that $10,000 has grown to $50,000, you pay no tax on the $40,000 gain. With a traditional 401(k), the initial investment is excluded from your taxable income, but you do pay taxes as you make withdraws from the account.

Why contributing to a Roth 401(k) may be a mistake

Determining whether a Roth 401(k) or traditional 401(k) is best requires a bit of guesswork. Traditional analysis asks whether your tax rate when you contribute to the Roth 401(k) will be different from the rate you have when you make withdrawals from the retirement account. If your tax rate will be the same, the argument goes, it makes no difference whether you invest in a traditional or Roth 401(k). A tax rate that is higher when you make contributions than when you take withdrawals favors a traditional 401(k), while a tax rate that is lower favors a Roth.

The problem with this analysis is that it glosses over the difference between the marginal tax rate and the effective tax rate. The federal tax rate is progressive, meaning that the tax rate increases as your income increases. For example, here are the 2008 federal tax brackets as released by the IRS:

2008 Tax Brackets

Tax Rate   Single                       Married Filing Jointly

10%            Not over $8,025        Not over $16,050

15%            $8,025 - $32,550        $16,050 - $65,100

25%            $32,550 - $78,850      $65,100 - $131,450

28%            $78,850 - $164,550    $131,450 - $200,300

33%            $164,550 - $357,700  $200,300 - $357,700

35%            Over $357,700           Over $357,700

As you can see, the tax rate increases as an individual or couple's income increases.

The marginal tax rate is the highest rate that people pay based on their income level. For those with taxable income of more than $357,700, the marginal rate is 35%. In contrast, the effective rate is the average income tax rate paid. Somebody with taxable income of $357,701, for example, pays 35% income tax only on the last $1. An individual would pay 33% for taxable income over $164,550, 28% for the portion of taxable income over $78,859, and so on. In the end, the effective tax rate would be the total tax paid divided by gross income, which would come out to a lot less than the marginal rate of 35%.

The key point for our purposes is that contributions to a traditional 401(k) reduce your tax liability at the marginal rate, not the effective rate. In contrast, withdrawals from a traditional 401(k) will be taxed, along with other retirement income, at your effective rate. So unless you expect your current marginal tax rate to equal or exceed your effective tax rate at retirement, the Roth 401(k) is not the best choice.

Wise choice?

Is a Roth 401(k) the right choice for anybody? Sure.

For those making in excess of $1 million, their effective tax rate and marginal tax rate begin to converge. Furthermore, they are likely to amass sufficient wealth such that their retirement income could exceed their current income, which could favor a Roth 401(k). Also, if you live in a state that doesn't have an income tax, but expect to move to a state that does during retirement, the Roth 401(k) may be the better choice. And a teenager who doesn't earn enough to pay taxes, but wants to save for retirement, would be better off choosing a Roth account.

Choosing the right investment vehicle is not a one-size-fits-all proposition. And it should be noted that you can invest in both a Roth and traditional 401(k). But for most, sound retirement planning suggests that we pass on the Roth 401(k).

Other articles of interest from The Dough Roller:

• 11 online retirement calculators

• Slow-motion retirement: A new way to look at the rest of your life
• How to buy partial shares of Berkshire Hathaway with ShareBuilder