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Roth 401(k): An Extraordinary Retirement and Estate Plan Opportunity

January 25, 2009 (update of an article originally published on May 7, 2006)

By Barry R. Milberg

Employers/plan sponsors may now add a Roth 401(k) feature to their new or existing plans.  This optional plan feature is available to all eligible plan participants because, unlike the Roth IRA, no one is prohibited from participating based on their adjusted gross income.

This article highlights the extraordinary retirement and estate planning opportunities the Roth 401(k) option affords to high net worth business owners and/or highly compensated employees who typically:

  • Are prohibited from contributing to Roth IRAs due to their adjusted gross income;

  • Desire maximum retirement benefits; and

  • Are not likely to outlive their pensions.

Learn more about "How to Avoid Roth 401(k) Compliance and Administration Pitfalls"

Roth 401(k) Analysis

The following examples illustrate the unprecedented retirement and estate planning opportunities afforded by the Roth 401(k) option.  The "control" examples serve to illustrate the Roth 401(k)'s benefits with regard to retirement planning.  They additionally serve as a foundation to illustrate its benefits with regard to one's estate plan. 

Control Example 1  This example examines the distribution outcomes for contributions to pre-tax and Roth accounts based on the following assumptions:

Participant Information: Male, age 51, earns $400,000 (capped at $245,000 the 2009 compensation limit), tax rate 35%.

Pre-tax Contribution: Maximum contributions for 5 years to a pre-tax account ($22,000 in 2009 subject to projected cost-of-living adjustments to the annual individual and catch-up contribution limits in minimum increments of $500).  Learn more about COLAs

Roth Contribution: Maximum contributions for 5 years net of tax to a Roth account (considers COLA).  The net of tax contribution is calculated based on the $20,500 maximum contribution limit less the tax due based on a tax rate of 35% [$22,000 (1-35%)], or $14,300.

Portfolio for Pre-tax and Roth: 60% stocks earning 8%, 40% bonds earning 5.5%, blended interest rate is 7%.

Distributions: At age 66, the pre-tax 401(k) account is rolled over to a pre-tax IRA and the Roth 401(k) is rolled over to a Roth IRA.  Distributions commence from each respective IRA account in equal annual payments starting at age 71 for a period of 15 years.  Note that the assets in a Roth IRA are distributed starting at age 71 even though they are not subject to the minimum distribution requirements while the pensioner is living.

Graphic Illustration provided by Roth 401(k) Analyzer Version 3.0

The pre-tax option is preferred if the individual's tax rate decreases to 28%, neither option is preferred if the tax rate remains at 35%, and the Roth option is preferred if the tax rate increases to 42%. 

Control Example 2  This example uses the same assumptions as control example 1 except the participant's Roth deferral is increased from $14,300 to $22,000.

The Roth option is preferred under all circumstances, but... 

Control Example 2 is flawed.  The comparison of outcomes resulting from a $22,000 contribution to both the pre-tax and Roth 401(k) accounts is not sound.  In this example, the contribution to the Roth 401(k) account costs this participant $33,846 [$22,000/(1-35%) = $33,846], not $22,000, since the 35% tax on the $22,000 contribution is $11,846.  Therefore, an after-tax savings account, or "side fund," is established to invest the after-tax proceeds of the $11,846, or $7,700 [($33,846 -$22,000) (1-35%) = $7,700]. 

Control Example 3  The same assumptions apply as in control example 2 except:

Roth Contribution: Maximum contributions for 5 years to a Roth account ($22,000 in 2009 subject to COLAs to the annual individual and catch-up contribution limits in minimum increments of $500).

Side Fund Contribution: $7,700 contributions for 5 years to an after-tax savings account (subject to COLA).

Side Fund Portfolio: 60% stocks earning 8% taxed at 15%, 40% tax free bonds earning 4.0%, blended interest rate is 5.68%.

Side Fund Distributions: Distributions commence from the side fund at age 71 and are added to the 15 years of net after tax pre-tax distributions.

Graphic Illustration provided by Roth 401(k) Analyzer Version 3.0

The Roth option is preferred in all instances even if the

tax rate decreases to 28% at the time of distribution.

Reason for unanticipated outcome  The Roth provides the ability to invest in various asset classes within its tax-free environment.  Assuming comparable risk factors on the selected investments, it is virtually impossible for a taxable side fund to perform as well as the tax-free Roth.  For example: Compare investing in a tax free bond earning 4% to taxable bond in Roth 401(k) account earning 5.5%, or investing in stocks that are never taxed compared to stocks taxed at 15% assuming qualification for long term capital gains treatment.

Conclusion The Roth option effectively permits one to save more for retirement.  The control examples illustrate that the Roth option provides a more favorable outcome even if the individual's tax rate decreases modestly during the distribution period.  Therefore, in most instances, it is the preferred choice to provide maximum retirement benefits for high net worth business owners and highly compensated employees who are maximum savers.

View Roth 401(k) Analyzer V3.0 Sample Reports

View more Roth 401(k) Case Studies

Estate Plan Opportunity  The previous examples established that the Roth 401(k) is generally preferable for most high net worth business owners or highly compensated employees.  The following examples highlight the estate planning opportunity the Roth 401(k)/Roth IRA affords to these same individuals.  They assume the individual postpones distributions of pre-tax assets until the required beginning date for minimum distributions (generally the April 1 following the attainment of age 70½) with the balance of the pre-tax assets distributed to designated beneficiaries in the year following the individual's death.  To mitigate the impact of distribution taxation, the beneficiaries elect to "stretch" the receipt of the balance over their respective life expectancies.  Minimum distributions are not required from either Roth IRA or savings accounts until the year following the pensioner's death.  This means that the entire Roth IRA account (and the after-tax side fund too) is paid to designated beneficiaries thereby "super-stretching" the tax free distributions over their respective life expectancies.

Example 4  This example illustrates the benefits of the Roth 401(k) option for individuals who want to delay retirement benefit distributions beyond age 70½.

Participant Information: Male, age 51, earns $400,000 (capped at $245,000 the 2009 compensation limit), tax rate 35%.

Pre-tax Contribution: Maximum contributions for 5 years to a pre-tax account ($22,000 in 2009 subject to projected cost-of-living adjustments to the annual individual and catch-up contribution limits in minimum increments of $500).  Learn more about COLAs

Roth Contribution: Maximum contributions for 5 years net of tax to a Roth account (considers COLA).  The net of tax contribution is calculated based on the $20,500 maximum contribution limit less the tax due based on a tax rate of 35% [$22,200 (1-35%)], or $14,300.

Pre-tax and Roth Portfolios: 60% stocks earning 8%, 40% bonds earning 5.5%, blended interest rate is 7%.

Distributions: At age 66, the pre-tax 401(k) account is rolled over to a pre-tax IRA and the Roth 401(k) is rolled over to a Roth IRA.  Minimum distributions commence at the required beginning date (generally the April 1 following the attainment of age 70½) from the pre-tax IRA account.  In the year following the death of the individual (age 82 based on death at age 81),  the balance in the pre-tax IRA, and all assets in the Roth IRA and side fund accounts, are distributed to his three children over their respective life expectancies (two males currently ages 17 and 15, and a female currently age 13) .

Graphic Illustration provided by Roth 401(k) Analyzer Version 3.0

The Roth provides a preferred outcome in all instances since no assets are distributed from the Roth account until the year following the individual's death at age 81.  This outcome does not consider reinvestment of the distributed pre-tax assets; however, even when considering the reinvestment of these monies, the Roth still provides a superior outcome since the it permits investment in asset classes within the tax-free Roth environment that yield a higher net after-tax rate of return (e.g., taxable v. tax free bonds, equities not subject to any capital gains tax).

Example 5  This example uses the same assumptions as example 4 except:

Roth Contribution: Maximum contributions for 5 years to a Roth account ($22,000 in 2009 subject to COLAs to the annual individual and catch-up contribution limits in minimum increments of $500).

Side Fund Contribution: $7,700 contributions for 5 years to an after-tax savings account (subject to COLA).

Side Fund Portfolio: 60% stocks earning 8% taxed at 15%, 40% tax free bonds earning 4.0%, blended interest rate is 5.68%.

Side Fund Distributions: Distributions commence from the side fund and are added to the net after tax pre-tax distributions.

Graphic Illustration provided by Roth 401(k) Analyzer Version 3.0

The examples above illustrate why the Roth 401(k) option provides an extraordinary retirement and estate plan opportunity.  The Roth 401(k) effectively permits this individual to save more for retirement and also provides the option to postpone tax-free distributions to beneficiaries until the year following death.  And one more estate plan benefit...

Additional “Gift”  By paying income tax now on contributions to a designated Roth 401(k) account, the pensioner effectively prepays federal income tax on money that passes to heirs without impacting gift or estate tax exemptions.

Learn more about Roth 401(k) Analyzer V3.0

View Roth 401(k) Analyzer V3.0 Sample Reports

View more Roth 401(k) Case Studies

Commentary  The Roth option permits those who do not anticipate the need for these funds during retirement to create a legacy for children or grandchildren.  Be mindful that this planning option is a potential benefit of the Roth, not necessarily one that must be used.  However, it does demonstrate that Roth assets should be the last funds drawn on by the pensioner, with any remainder passing to heirs who may elect to receive income tax-free distributions throughout their lifetime.

The Roth skeptics who argue that future tax rates are uncertain should consider that the future outcome of contributing 5 years to either a pre-tax or Roth option will have little, if any, impact on these individuals no matter what happens to future tax rates.  And those who believe that one should never pass up an opportunity to save taxes should consider that most of us simply do not save the dollars resulting from the tax deduction.  Learn more about Behavioral Finance

If your clients are high net worth business owners or highly compensated employees, why shouldn't they choose an option which essentially permits them to save more for retirement while also providing the potential to pass a significant amount of assets to heirs 100% free of income tax?

Access more Articles and Links on Roth 401(k)/403(b)

© 2006-2009  ERISA Expertise LLC  All Rights Reserved

The information provided is intended as a general resource, not as investment or retirement planning, or legal plan compliance advice or counsel.  If you consider any actions discussed in this update, we suggest that you consult a qualified planning, tax or ERISA professionalERISA Expertise LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this update.  Any tax advice included in this written or electronic communication is not intended or written to be used, and it cannot be used, by the taxpayer for the purpose of avoiding any penalties that may be imposed on the taxpayer by any governmental taxing authority or agency.

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