The Roth 401(k): "A Hidden Wealth-Transfer Treasure for High Income Taxpayers" - June 13, 2005
This article is the first in a series we intend to publish between now and January 1, 2006. Next up: "Five Reasons Why HCEs Should Choose the Roth 401(k)/403(b)"
As planning professionals and plan sponsors, you know by now that participants can contribute all or part of their 401(k) salary deferrals on an after-tax basis to a Roth 401(k) starting January 1, 2006. A Roth 403(b) feature is also available to participants in 403(b) plans on January 1, 2006. But do you know that the Roth 401(k) provides a retirement and estate planning treasure for our country's highest income taxpayers?
The technical overviews provided by the major law and consulting firms allude to, but don't reveal, this hidden treasure. The investment experts at the Motley Fool also wrote about it, but so far, they too got fooled. This retirement and estate planning bonanza remains buried in the EGTRRA legislation passed into law back in 2001.
Perhaps a treasure map exists within the law?
Could it be that the Roth 401(k) permits tax-free growth on after-tax contributions? You're COLD.
Could it be that qualified distributions from the Roth 401(k) are 100% income tax-free? You're getting WARMER...
Could it be that, unlike the Roth IRA, all plan participants can contribute to a Roth 401(k), regardless of their adjusted gross income? You're HOT!
What is the map to this hidden wealth-transfer treasure?
THE ABILITY TO ROLL OVER A ROTH 401(k) TO A ROTH IRA!
Why is this the map to the treasure? The plan participant retires and rolls the Roth 401(k) account over into a Roth IRA; where it is no longer subject to the minimum distribution requirements. This means that plan participants can delay distributions indefinitely until death, at which time their heirs have the option to receive distributions throughout their lifetime.
Why is this significant for high income taxpayers? Because they typically can afford to delay the distributions, especially if it means a favorable economic outcome for themselves while living, or to their estate after death.
How do we prove this map yields a favorable economic outcome? We use the Roth 401(k) AnalyzerSM to compare the accumulation and distribution outcomes for a pre-tax contribution to a traditional 401(k), the equivalent after-tax contribution to a Roth 401(k) and a Savings Plan, and the maximum after-tax contribution to the Roth 401(k) considering the:
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Plan participant's date of birth, current tax bracket and assumed age at death
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Beneficiary's relationship, date of birth, tax bracket at distribution and assumed age at death
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Amount and number of years the participant contributes to a Roth account
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Pre-tax and Roth 401(k) portfolio composition and assumed rate of return
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After-tax savings plan portfolio composition and assumed rate of return
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Plan participant's and beneficiary's beginning ages and tax brackets for distributions
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Life Expectancy Rule for distributions to the plan participant and the beneficiary
To learn more about how the Roth 401(k) AnalyzerSM assists plan participants and employer/plan sponsors to determine the viability of this optional plan feature, go to: http://www.roth401kinfo.com
Case Studies
The case studies that follow assume that the participant retires at age 65 and rolls over the pre-tax 401(k) account balance into an IRA and the after-tax Roth 401(k) into a Roth IRA.
Case Study 1: This study serves to illustrate that the Roth 401(k) provides no advantage over a traditional pre-tax 401(k) by comparing the maximum pre-tax 401(k) to the equivalent after-tax Roth 401(k) and savings plan, and maximum permissible Roth 401(k).
Starting January 1, 2006, the 50 year old plan participant in a 35% tax bracket with a spouse age 40 contributes $20,000 to the pre-tax 401(k), and the equivalent after-tax $13,000 contribution to the Roth 401(k) and Savings Plan for 5 years since the law "sunsets" in 2010. A 60% stock/40% taxable bond portfolio generates a blended 7% rate of return for the pre-tax and Roth 401(k); a 60% stock/40% tax-free bond portfolio generates a blended 5.68% rate of return for the after-tax Savings Plan (See Footnotes below for explanation of assumptions).
In this case study, for comparison only, distributions start from all plans at the required beginning date of age 71 based on the minimum distribution requirements which apply to the pre-tax 401(k) only. All plans distribute the assets tax-free except the pre-tax 401(k) which are taxed assuming a 35% tax bracket. Distributions continue until the assumed death of the participant at age 87 and the beneficiary at age 92. The account balance remaining at the beneficiary's death is included in the total distributed assets.
Commentary: Case Study 1 illustrates that the $13,000 after-tax equivalent contribution to a Roth 401(k) provides no advantage as compared to the $20,000 pre-tax contribution to a traditional 401(k) since the participant's tax bracket remains static during accumulation and distribution. However, this age 50 plan participant may contribute up to $20,000 after-tax to the Roth; therefore, assuming the participant has the means to contribute the higher after-tax amount, the Roth 401(k) is advantageous as compared to the other available savings plans. As the graph above indicates, if the participant contributes $20,000 to either the pre-tax or the Roth, the total accumulation is the same.
Case Study 2: All facts are the same as in Case Study 1 except the tax bracket increases to 40% for the participant and beneficiary starting with the first distribution at age 71.
Commentary: Case Study 2 illustrates that the Roth 401(k) provides a $29,038 advantage over the pre-tax 401(k) since the tax bracket increases starting with the first distribution at age 71.
Case Study 3: All facts are the same as in Case Study 1 including the static tax rate and the roll over of the Roth 401(k) to a Roth IRA at retirement age 65. However, in this example, the plan participant delays the first distribution of the Roth 401(k) and the after-tax Savings Plan until age 76 (vs. the required minimum distributions starting at age 71 for the pre-tax 401(k)/403/(b)).
Commentary: Case Study 3 illustrates that the Roth 401(k) provides an $55,144 advantage over the pre-tax 401(k) since the Roth IRA is not subject to the Age 70½ required beginning date for minimum distributions. This case study does not consider any income on the pre-tax 401(k) distributions if they were reinvested; however, even considering the additional income on this now taxable investment, the Roth still provides a significant advantage.
Case Study 4: All facts are the same as in Case Study 1 including the static tax rate and the roll over of the Roth 401(k) to a Roth IRA at retirement age 65. However, in this example, the participant delays the first distribution of the Roth 401(k) and the after-tax Savings Plan until age 87, the assumed age at death (vs. the required minimum distributions starting at age 71 for the pre-tax 401(k)/403/(b)). The plan participant also designates his 16 year old daughter as his beneficiary. She receives distributions from the plan participant's Roth IRA based on her life expectancy starting at age 53 until her death at age 90. The account balance remaining at death is included in the last payment.
Commentary: Case Study 4 illustrates that the Roth 401(k) provides a $525,018 advantage over the pre-tax 401(k) since the Roth IRA is not subject to the Age 70½ required beginning date for minimum distributions. The after-tax Savings Plan provides a $51,623 advantage as well, assuming the delay in the first distribution until after death. This case study does not consider any income on the pre-tax 401(k) distributions if they were reinvested; however, even considering the additional income on this now taxable investment, the Roth and Savings Plan still provide a significant advantage.
Closing Commentary
The case studies illustrate that the Roth 401(k) warrants immediate attention by plan participants, employer/plan sponsors, third party plan administrators, and retirement, estate and investment planning professionals. Delaying the implementation of this dynamic new plan feature can mean the loss of a significant planning opportunity, especially for high income taxpayers.
Small employers (owner-only businesses and those with up to 100 employees) who sponsor SEPs and SIMPLES should now consider a 401(k) plan to take advantage of this unique planning opportunity that may last only 5 years. Even hyper-net worth individuals who typically disregard these plans should consider the benefits of the wealth-transfer technique discussed in this article.
Bottom line: The time is now for all interested plan sponsors and service providers to start working towards the implementation of required plan amendments, employee communications, recordkeeping, administration and reporting systems modifications to facilitate the addition of this new plan feature on January 1, 2006.
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Milberg Consulting LLC welcomes this opportunity to share its knowledge and foresight on the Roth 401(k) with our industry colleagues. We invite you to learn more about the Roth 401(k) Analyzer and how to make the Roth 401(k) a winning proposition for you, your clients and their plan participants by going to: |
Interested in scheduling an onsite, web or video conference on the Roth 401(k) for advisors, clients and/or prospects? Contact:
Barry Milberg at (215) 793-4300 or bmilberg@erisaexpertise.com
2006 401(k) Limit: $15,000 401(k) and $5,000 "catch-up" for individuals age 50 or older in calendar year 2006
Equivalent Roth 401(k): $20,000 pre-tax is equivalent to $13,000 after-tax in a 35% tax bracket
Savings Plan: The $13,000 after-tax equivalent contribution of the $20,000 pre-tax 401(k) contribution invested in a taxable savings account comprised of 60% stock earning 8%, subject to 15% capital gains tax, and 40% tax-free bonds earning 4%.
Sunset: The phrase: "the law sunsets in 2010" means that the law expires at the end of 2010, or 5 years after the date the Roth 401(k) is first available on January 1, 2006.
Rate of Return: Pre-tax and Roth 401(k) 60% stock portfolio earns 8%, 40% bond portfolio earns 5.5%; After-tax Savings Plan 60% stock portfolio earns 8% subject to 15% capital gains tax, 40% tax-free bond portfolio earns 4%.
© 2005 Milberg Consulting LLC All Rights Reserved
We intend the information in this publication as a general resource, not as legal or plan compliance advice or counsel. If you consider any actions discussed in this update, we suggest that you consult a tax or ERISA professional. Milberg Consulting LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this update.