What's the Bottom Line on Who Should Consider the Roth 401(k) Option? - December 12, 2005

As January 1 approaches, employer/plan sponsors and their advisors must:

ü    Understand the rules;

ü    Modify all plan forms;

ü    Ensure that third party administration (compliance), payroll, and investment vendor systems can accommodate the administrative, recordkeeping and reporting issues unique to the Roth feature; 

ü Prepare formal plan modifications and disclosure to participants (IRS Notice 2005-95 re-affirms the timing for plan amendments); and

ü Conduct meetings and/or provide written communications with a clear understanding of...

Who Should Consider the Roth 401(k) Option?

Individuals who believe their tax rate will be higher during 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... 

1. If you are in an entry level position and you believe your income will increase significantly in the future, it's a good bet that your tax rate will be higher in the future, but Watch-out!  If contributing to the Roth option results in a lower plan contribution, you may not qualify for the maximum employer match; Learn more (for roth401kinfo.com subscribers only)

2. If your tax rate during retirement will remain the same or be higher due to loss of deductions for mortgage interest payments, tax credits for child care, etc., and you intend to live primarily on Social Security benefits and tax-deferred retirement assets that will be subject to income tax (federal and possibly state income tax as well), you may find yourself paying tax at the same or higher rates during retirement;

3. If you are currently in a lower bracket today because you have structured your income to mitigate taxable income (e.g., you are currently receiving relatively significant deductions for charitable contributions and/or your income is received from sources such as tax-free bonds or non-taxable dividend income) and you anticipate an increase in your taxable income during retirement, then contributing to the Roth while paying lower taxes should provide you greater benefits during retirement; and

4. If you have significant retirement assets (qualified and/or non qualified) that will require you to take minimum distributions that will result in paying a higher tax rate, you should consider contributing to the Roth option.

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 their retirement 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.

Working 5%+ owners who are typically required to take minimum distributions from their retirement plans and IRAs can defer after-tax dollars in a Roth 401(k), take an in-service distribution of these assets, transfer the distribution to a Roth IRA, and circumvent the minimum distribution requirement.

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)

News Release (December 7, 2005):  ERISA Expertise LLC Releases New Roth Analyzer and Employer Guides and Price Reduction

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