Who Should Consider the Roth 401(k) Option?
December 12, 2005
As January 1 approaches, employer/plan sponsors and their advisors must:
Who Should Consider the Roth 401(k) Option?
Individuals who believe their tax rate will be higher in retirement than today.
This is the most obvious yet the toughest of all of reasons to nail down on an individual basis because no one really knows where tax rates will be in the future. However...
Individuals who wish to diversify future tax risk.
Prudence dictates that one should diversify investments in accounts or investment vehicles that are taxed differently (i.e., taxable, tax-deferred, tax-free). The Roth 401(k) provides a very attractive alternative to tax-free investing as compared to traditional tax-free investments such as tax-free bonds. Since no one really knows what the future holds for tax rates, why not invest a portion of your retirement assets in a Roth account?
Individuals who want to maximize retirement benefits and facilitate prepayment of income tax for estate planning purposes.
If you can afford to contribute the maximum after-tax contribution (which reduces your income by a higher amount than the pre-tax option since you pay tax now), the Roth option allows you to save more for retirement. In addition, by paying income tax now on the Roth 401(k) contributions, the participant effectively prepays federal income tax on money that passes to heirs without impacting gift or estate tax exemptions. Learn more
This is of particular interest to HCEs whose contributions are limited by “401(k) nondiscrimination test” and small business owners who do not receive retirement benefits beyond that of the maximum 401(k) limit (and perhaps a "safe harbor" employer contribution) since it is not in their personal economic interest to make additional employer contributions to their company profit sharing plans.
Individuals who wish to take advantage of a limited time offer that may not be available after 2010.
The Roth 401(k) is the first and only qualified retirement plan feature that permits tax-free accumulation of after-tax contributions by participants of all income levels, and allows the tax-free distribution of the contribution and accumulated earnings. Unless current law is extended, it will not be available after the year 2010.
Individuals who want to delay distributions of benefits beyond age 70½.
Roth IRAs are not subject to required minimum distributions; therefore, the postponement of distributions until after death appeals to those with substantial savings and no need for income from Roth savings. If the participant leaves substantial assets to heirs, it is generally recommended that they defer receipt of tax-deferred assets until minimum distributions are required. Payments to younger spousal or nonspousal beneficiaries “stretch” tax-deferred payments to mitigate tax impact. The Roth IRA allows pensioners to “super stretch” payments to beneficiaries since no distributions are required until after death.
Others that may consider the Roth option could include...
Individuals who wish to receive tax-free income during retirement to mitigate the possibility of taxing Social Security payments;
Individuals who believe that future tax rates will be higher for all; and lastly (for no objective reason whatsoever)...
Those individuals who desire to receive tax-free income during retirement.
Commentary There is no “one size fits all” answer for employers and participants considering the Roth option, but knowledge of the rules and projections of future outcomes can provide meaningful guidance. You do not need a crystal ball to see that the Roth 401(k) affords significant retirement and estate planning opportunities for taxpayers of all income levels.
Access more Articles and Links on Roth 401(k)/403(b)
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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 professional. ERISA 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.