Why Not Just Millennials Ought to ROTH their 401(k) Deferrals Early and Often

2016 Alliance sponsor feature article by Gordon Asset Management, LLC

Both Roth IRA’s ($5,500 in 2016 and $500 catch-up) & Roth 401(k)s offer numerous  tax advantages for millennials and middle class American workers. Roth 401(k)’s are often overlooked, however, because not all 401(k) or 403(b) plans offer the Roth option, due to the need for a plan amendment and associated additional record keeping costs.

If offered, Roth 401(k) deferrals can create significant after-tax wealth inside a 401(k) plan since 100% of the elective deferral of $18,000 ($24,000 if age 50 or more) can be designated as Roth. Since the taxes are paid up front, all earnings grow tax-free; withdrawals (post age 59 ½) are completely tax-free for life with no required minimum distributions.  Many high income earners regret not having Roth 401(k) available earlier in their careers when it made the most sense to Roth your deferrals. Why?  Because the opportunity to pay tax only once on contributions and never on earnings is a huge windfall towards building lasting wealth.  When you are younger, you are typically in a lower income tax bracket than in peak earning years.

For those individuals & couples in the 15%-25% marginal tax bracket, Roth deferrals are increasingly advantageous.  Married couples do not leave the 25% federal bracket (Tax-Year 2016) until taxable income exceeds $151,900; or $91,150 for singles, while the 15% tax bracket is capped at $75,300 & $37,650, respectively. When you consider that married couples have at least two $4,000 annual exemptions and a standard deduction of $12,600, at a minimum, is it any wonder why most 401(k) participants are not electing to Roth their deferrals?  In 2016, a married couple above earning less than $95,900 in gross wages, after exemptions and the standard deduction, are still only in the 15% federal tax bracket.  There is no better financial planning advice than to urge these folks to use the Roth provision and pay 15% once on contributions and never on earnings.

What if a couple makes $115,000 to $120,000? They can save 25% in federal taxes by electing pre-tax deferrals to the threshold of the 15% tax bracket at $95,900, and then Roth the remaining deferrals.  In 2015, we had an empty-nester couple who did just that, namely, one spouse elected pre-tax ($24,000) deferrals to reduce taxable income from $120,000 to $96,000, then the other spouse chose a Roth deferral for $18,000, subject to 15% federal tax once,  since she was under age 50.

So, why wouldn’t someone whose current taxable income falls within, or below, the 25% tax-bracket choose to take advantage of a Roth Provision? The answer is the risk factor of changes in future tax laws?  This wouldn’t be the first time a change in tax law had a severe impact on the financial planning landscape. The original Social Security legislation provided for tax free benefits from the time the law was passed in the 1930’s until 1980’s legislation altered the law, nearly 50 years later.  Now up to 85% of the benefits are taxable.  Also, many accountants and advisors have recently learned of the negative changes to many file and suspend tactics in social security planning taking effect in 2016.

So how can you show a millennial how to turn $180,000 into over $1,500,000 tax free?

Suppose a millennial age 28 earning $50,000/year, is pondering Roth 401(k) deferrals of $18,000, the legal maximum in 2015. Since all of the income is taxed 15% at the federal level, and 5.75% in North Carolina, as an example, the benefit of the Roth is derived from paying the tax up-front, in a low 15% bracket, and then benefit from tax-free earnings and ultimately, tax-free income. This millennial contributes $18,000/yr. for 10 years, through age 38. Even if contributions were suspended at age 38 to raise a family, the account balance 20 years later would have grown to $760,000, assuming a 6% rate of return.

At age 59 ½, the Roth can also be tapped for college expenses if needed, or just receive tax-free growth until normal retirement age.  Assuming it grows tax-free until age 70, when elective withdrawals begin for retirement income, the account has now grown to $1,531,000. At a 5% withdrawal, this account can provide over $76,000/yr. in tax free income for life.  And no required minimum distributions!

Not bad for only making 10 years of $18,000/yr. in contributions!

This article has been written by Gordon Asset Management, LLC (GAM).  The information provided in this publication is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. GAM makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of or reliance on the information. This information is subject to change and, although based on information that GAM considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data supplies. Past performance is no guarantee of future results. Advisory services through GAM, an SEC-registered investment advisor.  More information about GAM its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (866) 216-1920.

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