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CONSIDERING A ROTH 401(k)? CONSIDER THIS.

December 20, 2005

One of the factors in deciding whether to use the new "Roth" 401(k)s that become available January 1 is whether your tax rate at retirement might lower than it is now. A new report by the Congressional Budget Office makes a sobering case that tax rates are going nowhere but up over the long term:

Driven by rising health care costs and an aging population, federal spending for Medicare, Medicaid, and Social Security will claim a sharply increasing share of the nation’s economic output over the coming decades.

Even if taxation reached levels that were unprecedented in the United States, current spending policies could become financially unsustainable. An evergrowing burden of federal debt held by the public would have a corrosive and potentially contractionary effect on the economy.

As the U.S. tax system is now configured, federal revenues will grow faster than the overall economy. Under current law, taxpayers will face higher rates, with detrimental consequences for work, saving, and economic growth.

If taxation is restricted to the levels that prevailed in the past, the growth of spending on programs for the elderly will have to be reduced substantially. Limiting the growth of outlays for defense, education, transportation, and other discretionary programs would not be enough to ensure fiscal sustainability.

Likewise, economic growth alone is unlikely to bring the nation’s long-term fiscal position into balance. Moreover, issuing ever-larger amounts of debt or dramatically raising tax rates could significantly reduce economic growth.

In a "Roth" 401(k) plan, you don't get a current tax break for deferring part of your salary; instead, if you meet certain conditions, withdrawals from the plan are tax-free forever. This is different from conventional 401(k) deferrals, which are excluded from taxable income currently but are taxable on withdrawal. If your tax rate will be lower at retirement, Roth 401(k)s aren't as attractive.

There are many factors besides tax rates to consider in evaluating a Roth 401(k); this article covers them well.

Hat tip: Tax Policy Blog, which has some eye-opening charts to illustrate the dilemma.

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