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    New From Your Employer: The Roth 401(k) Plan

    by Peter James Lingane

    New From Your Employer: The Roth 401(k) Plan Splash image

    Important changes may be in store for your employer-sponsored retirement plan. Starting this month, 401(k) plans, 403(b) plans and potentially the federal Thrift Savings Plan are allowed to accept aftertax elective deferrals. Elective deferrals to other types of plans, and all employer contributions including any employer match, remain on a pretax basis. If your employer amends their plan documents to allow for aftertax elective deferrals, you will have a choice between making a pretax or aftertax contribution. This article illustrates how you might approach this decision.

    Tax-Advantaged Plan Basics

    Employer-sponsored plans are often categorized as being either defined-benefit or defined-contribution plans. Defined-benefit arrangements are considered distinct from 401(k) defined-contribution plans, 403(b) tax-sheltered annuities, 457 deferred-compensation plans and traditional, SIMPLE or SEP-IRAs because each of these retirement savings vehicles has their own, and sometimes unique, characteristics.

    This distinction is less important from an investment perspective because all of the aforementioned plans are “traditional-style” retirement saving vehicles. That is,

    • Contributions are made with pretax dollars, and
    • Distributions are taxed as ordinary income.
    This distinction is also less important from an investment perspective because traditional-style plans are fungible. The Internal Revenue Code allows all but certain 457 plans to be rolled over to a traditional IRA without tax consequences.

    The other attractive retirement savings vehicle is a “Roth-style” plan.

    • Contributions are made with aftertax dollars, and
    • Distributions are tax-free under specified conditions.
    The Roth-style category includes Roth IRAs and now the new Roth-style elective deferral plans. All Roth-style plans can be rolled over to a Roth IRA. Rollovers allow an investor to finesse limitations of a particular plan. For example, a rollover from a Roth-style elective deferral plan to a Roth IRA should avoid the minimum distributions that are otherwise required from about age 70.

    The important distinction between traditional and Roth-style retirement savings vehicles is that the government is your partner with a traditional plan. The aftertax value of your contributions, and the earnings thereon, constitute your share while the tax that is deferred at the time of contribution, and the earnings thereon, constitute the government’s share.

    Suppose that your employer limits your elective deferral to $15,000 annually. Assume that you can afford to contribute the limit if you receive a tax deduction (using a traditional plan) but that you could not afford the limit ifyou had to use aftertax dollars for the full amount.

    If you contribute $15,000 pretax to a traditional-style plan, your share will be worth $10,000 initially (assuming a 33% tax rate) and the government’s “share” will be $5,000 initially.

    If the rate of tax to be paid on future distributions from a traditional-style plan (in other words, when you retire) is higher than the rate of tax deferred at the time of contribution, the government’s share will increase, at the expense of your share.

    A lower tax rate when taking distributions means that your share of a traditional-style plan will increase, at the expense of the government’s share.

    Changes in tax rates do not affect Roth-style plans because there is no deferred tax and no government share.

    You will have exactly the same aftertax value in retirement on contributing $15,000 pretax dollars to a traditional plan as you will contributing $10,000 aftertax dollars to a Roth-style plan so long as there are no changes to the tax rates. The aftertax return on a Roth-style plan is exactly the same as the return on your share of a traditional plan as long as the government’s share of the traditional plan does not change. You will have more aftertax dollars in retirement with a Roth-style plan if your future tax rate is more than your current tax rate and more aftertax dollars with a traditional plan if your future tax rate is less.

    This illustrates the importance of estimating future tax rates.

    Let’s now assume that you can afford to contribute the plan limit in aftertax dollars. This changes the calculus. Your choice is now between a traditional-style plan where your share is valued at $10,000 initially plus $5,000 in tax savings that you can put into a taxable account, and a Roth-style plan where your share is valued at $15,000 initially.

    Assuming the same investments and fees in all accounts, you will have more aftertax dollars in retirement with the Roth-style plan because you will have had more dollars earning a higher aftertax return in a tax-advantaged environment. This statement assumes no change in tax rates.

    Under this scenario, if your future tax rate is likely to be more, a Roth-style plan is favored both because you can shelter more aftertax dollars in a Roth-style plan and because the government’s share of your traditional plan will increase.

    If your future tax rate is likely to be less, your situation requires further analysis. You will earn a higher aftertax return on more money with a Roth-style plan but you will keep a larger share of a traditional plan.

    Investors willingly pay extra if an investment is good enough. Similarly, investors should be willing to pay a bit more tax in order to invest more at a higher aftertax return so long as the increase in return is big enough and the investment timeframe is long enough.

    The decision as to a pretax or aftertax contribution ultimately depends on your answers to the following questions:

    • Can you afford to contribute the plan limit with aftertax dollars?
    • Will the rate of tax paid on distributions in retirement be less than the rate of tax deferred at the time of contribution?
    • What is the increase in return by investing more in the tax-advantaged environment? And
    • What is your investment timeframe?

    Average Tax Rate onDistributions

    Let’s assume that a married couple has rolled over all of their retirement savings vehicles to traditional IRAs. These IRAs must be distributed from about age 70 according to an IRS schedule. Two tax forecasts are generally needed to estimate the average tax paid on these distributions. The first includes all income while the second excludes the IRA distributions.

    The difference in cumulative tax in the two forecasts divided by the cumulative distribution is the average rate of tax paid on the distributions. When a couple live comfortably on their required IRA distributions and other income, the amount and timing of distributions are specified by the IRS rules, making it straightforward to forecast the average tax paid as a function of plan size. This is shown in Table 1. [Note that values are expressed in constant dollars because this provides a better appreciation of future value and also simplifies the tax calculations.]

    Table 1. Average Federal Tax on Traditional IRA Plan Distributions*
      Value of Traditional IRA at Age 65
    $100,000 $500,000 $1 Mil $2 Mil $5 Mil
    Acceleration of Distributions 10% 13% 19% 23% 29%
    No Acceleration of Distributions 14% 21% 23% 26% 31%
    Acceleration Benefit $4,000 $40,000 40,000 $60,000 $100,000

    If their IRAs were valued at $1 million, a married couple might pay 23% federal tax on the distributions.

    You must add state income taxes, if appropriate, to the average federal rate to obtain the total tax burden. If you think that the pre-2001 federal tax rates will be restored, add three percentage points to the tabulated values. Higher rates would apply for single taxpayers.

    When someone lives comfortably on their required distributions and other income, the value of their traditional IRAs late in life should be relatively large. For example, a $1 million IRA at age 65 growing at 5% real rate of return is still $1 million at age 90 if taking only the required distributions.

    Large balances in traditional-style plans late in life generally increase the average tax rate. There won’t be large balances if you are not in comfortable circumstances, or if your investments underperform. There won’t be tax if the balances pass to charity. And your heirs may be able to avoid high tax rates by “stretching-out” distributions over their lifetimes as is allowed under the current distribution rules.

    But large balances late in life will increase the average tax rate if these balances must be distributed, if your estate plan calls for a deathbed conversion (of the financial variety!) or if Congress eliminates the stretch-out option.

    Consequently, you can generally reduce the average tax on distributions from traditional-style plans by eliminating the risk of large balances late in life. This can be done by taking larger distributions than called for under the minimum distributions rules.

    The excess over the required distribution is converted to a Roth IRA. [The required distribution and the amount converted are not counted for purposes of the adjusted gross income limitation.]

    Conversion usually requires consideration of the same factors that affect the pretax or aftertax contribution decision. However, converting always makes sense when it reduces future average tax rates. Thus, accelerating distributions does not reduce your aftertax investment return or risk your financial security—it simply reduces the average rate of tax paid.

    Table 1 also shows the potential tax savings from accelerating distributions for those in comfortable circumstances. Accelerating distributions from a $1 million traditional IRA has the potential to reduce the average federal tax rate from 23% to 19%, thus saving about $40,000 in federal tax.

    Return Differential

    The average rate of tax paid on future retirement distributions is often less than the rate of tax deferred on current contributions. If this is your situation and you are already saving all that you can afford, you should probably contribute on a pretax basis for the reasons already discussed.

    If you can afford to save more, it makes sense to contribute on an aftertax basis if the return differential, the difference between the aftertax returns inside a Roth-style plan and inside your taxable account, is large enough.

    The return differential depends on your investment strategy. The return differential is lowest when measured with respect to an infrequently traded stock portfolio, somewhat higher for a fixed-income portfolio and higher still when compared to an actively traded portfolio.

    An investor should own those investments with special tax treatments in taxable accounts because tax-advantaged environments cancel special tax treatments. For example, a taxable portfolio should generally hold stocks because appreciation within a traditional plan is taxed as ordinary income rather than at capital gains rates.

    This suggests that the reference portfolio will generally be a stock portfolio. That is, the choice is to contribute the limit to a Roth-style plan, or to contribute the limit pretax to a traditional plan and invest the deferred tax in a taxable account, but to buy the same stock portfolio for all accounts.

    If the market grows 8% annually and distributes a further 2% in dividends, and if the investor pays 33% state and federal tax on these dividends each year and 20% tax on the gains after 20 years, the investor earns 8.5% aftertax on an annualized basis in a taxable account. The same investments grow 10% on an annualized basis in a Roth account. That is, the return differential might be as low as 1.5%. I encourage you to estimate the return differential based on your own investment strategy and tax situation.

    The Investment Timeframe

    We now know how to forecast the average tax rate on retirement distributions and how to estimate the return differential. The remaining issue is how to estimate the timeframe over which you might benefit from improved returns if you were to invest the limit, aftertax, in a Roth-style plan.

    The investment timeframe extends from the date of contribution to the date of death for those in comfortable circumstances. The expectation is that there will be IRA balances late in life, meaning that the contribution will, in effect, not be distributed before death.

    The date of death is uncertain. My solution is to use not one timeframe but a series of timeframes based on life expectancy tables. For example, the benefit of a pretax contribution might be $1,000 if the saver dies at age 66; i.e., a pretax contribution is favored in the event of an early death. If the chance of death at age 66 were 1%, the timeframe ending at age 66 contributes $10 to the total benefit.

    If the benefit of a pretax contribution were a $1,000 loss at age 90 (i.e., an aftertax contribution is favored in the event of a long life), and if the chance of death were 4% at age 90, this timeframe contributes a $40 loss to the total benefit.

    The total benefit is the sum of the contributions from ages 66 to 100. A positive benefit favors traditional, pretax contributions and a negative benefit favors Roth-style, aftertax contributions.

    Roth … or Traditional?

    Table 2 illustrates the combinations of current and future tax rates that favor before or aftertax contributions.

    Table 2. Favored Plan Based on Current and Future Tax Rates amd Age
    Current
    Tax
    Rate
    Future Average Tax Rate
    5% 10% 14% 19% 25% 30% 35% 42%
    Favored Plan/Maximum Age for Roth Contribution*:
    10% Trad’l Trad’l/65 Roth Roth Roth Roth Roth Roth
    15% Trad’l Trad’l/65 Trad’l/65 Roth Roth Roth Roth Roth
    25% Trad’l Trad’l/40 Trad’l/55 Trad’l/65 Trad’l/65 Roth Roth Roth
    35% Trad’l Trad’l Trad’l/40 Trad’l/55 Trad’l/65 Trad’l/65 Trad’l/65 Roth
    42% Trad’l Trad’l Trad’l Trad’l/45 Trad’l/60 Trad’l/65 Trad’l/65 Trad’l/65

    Someone in a 15% federal tax bracket today who expects to amass $1 million in retirement savings is likely to be better off with aftertax, Roth-style contributions because they might pay 19% tax on distributions in retirement.

    This is indicated by “Roth” at the intersection of the row headed “15% current tax rate” and column headed “19% future average tax rate.” If your future tax rate is less than the rate of tax deferred on your contributions, the general recommendation is for pretax, traditional-style contributions. This is indicated by the abbreviation “Trad’l” at the appropriate intersections of the table.

    If you can afford to contribute the plan limit on an aftertax basis, an aftertax contribution might make sense if you are not too old. For example, the entry at the intersection of 35% current tax and 19% future tax is labeled “Trad’l/55” because someone 55 or younger might benefit from the maximum Roth-style contribution.

    Table 2 should be applied cautiously. I encourage you to modify the table entries to reflect your personal circumstances.

    If your situation is ambiguous, I’m inclined to favor pretax contributions because you may be able to increase the plan value—and future worth—by converting to a Roth IRA at a later date if your circumstances dictate.

    This same analysis applies to a Roth conversion if the tax is paid from taxable investments. In this case, the “current tax rate” would refer to the tax rate paid on the amount converted.

    Less Tangible Considerations

    The minimum distribution rules limit the growth of traditional IRAs after about age 70. The beneficiaries of a Roth IRA, therefore, receive a larger fraction of their inheritance in the form of a tax-advantaged savings vehicle than do the heirs of a traditional IRA.

    If your heirs have an immediate need for the money, the relative valuation of the IRA to other assets may not be material. But if your heirs have the discipline to take distributions from the IRA gradually over their lifetimes, your heirs would receive substantially more from a Roth IRA than they would from a traditional IRA, even though the combined values of your taxable and IRA bequests might be the same.

    Estate taxes have become a less pressing planning consideration as the amount passing free of tax has increased. Those fortunate to have enough to be required to pay this tax, and who must use IRA assets to fund bypass (exemption) trusts, are better off with aftertax contributions because the amount of money passing to the trust is measured in nominal terms.

    That is, allocating a $2 million Roth IRA to the bypass trust shields $2 million (plus appreciation) from estate tax. Allocating a $2 million traditional IRA to the bypass trust shields less than $2 million (plus appreciation on less than $2 million).

    Caveats

    The IRS plans to issue regulations governing distributions from Roth-style 401(k) and 403(b) plans. While we know, in principle, that these plans can be rolled over to Roth IRAs and that distributions are not taxed after age 59½ and five years, there will be surprises when the IRS announces how these principles are applied in specific situations.

    Be sure to weigh any future tax policy carefully. A future increase in tax rates favors a Roth contribution today. But a reduction in future tax rates (as was recommended in the November 2005 report of the President’s Advisory Panel on Federal Tax Reform) or a future value-added tax (which was not recommended) favors a traditional contribution today.

    This article would have been dreadfully complicated if I had written it with absolute precision. It is therefore important that you educate yourself about the nuances of these issues, or seek competent advice.


    Peter James Lingane, EA, CFP, owns Financial Security by Design, a tax and financial advisory service specializing in retirement and estate planning. His firm is based in Lafayette, California.

    An appendix linked to the on-line version of this article at www.aaii.com provides the details of the calculations made in this article.


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