Roth 401(k): Significant Retirement and Estate Planning Opportunities for Business Owners/HCEs

May 7, 2006

By Barry R. Milberg

As the 2006 plan year progresses, only a limited number of small employers (those with 1 to 500 employees) are adding the Roth feature to their new or existing plans.  Are plan advisors and service providers really trying to sell this option to their clients or just framing it as an administrative burden?  By now most are familiar with the Roth 401(k) option but apparently very few realize the extent of its potential benefits.  

The skeptics are quick to point out the obvious...  Adding the Roth option complicates administration, who knows what the future brings for tax rates, and when does it ever make sense to give up a tax deduction? 

It's certainly true that adding a Roth option does require additional record keeping, administration and reporting requirements; however, the recently issued final and proposed regulations for Roth accounts provide guidance with regard to these requirements, and in Notice 2006-44 the IRS provides a sample Roth 401(k) plan amendment.  Furthermore, the Roth requirements are no more onerous than those required for proper administration of loans or hardship withdrawals; however, be mindful that...

Plan service providers are not the only ones involved in proper administration of the Roth option.  Employers who elect to add this feature to their new or existing plans must also determine if their payroll vendor can facilitate the taxation and W-2 reporting requirements associated with Roth deferrals.  FYI, we've added this feature to 50+ client plans including our own plan and have yet to encounter a payroll vendor who shunned the addition of the Roth.

Learn more about the Roth 401(k) final regulations

Learn more about the proposed regulations for distributions from Roth accounts

Access Notice 2006-44: Sample amendment to add Roth 401(k)

So much for what employers, advisors and service providers should consider.  This article highlights retirement and estate planning opportunities that the Roth option affords to high net worth business owners and/or highly compensated employees who typically are:

• Prohibited from contributing to Roth IRAs due to the extent of their adjusted gross income;

• Desirous of maximizing retirement benefits;

• More likely than most not to outlive their pensions; and

• Empowered to add the Roth feature to their new or existing plan.

Roth 401(k) Analysis

The examples that follow illustrate the unprecedented retirement and estate planning opportunities afforded by the Roth option.  The "control" examples serve to illustrate the Roth's retirement planning opportunity and as a foundation to illustrate the estate planning opportunity. 

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 $220,000 the 2006 compensation limit), tax rate 35%.

Pre-tax Contribution: Maximum contributions for 5 years to a pre-tax account ($20,000 in 2006 subject to a 3% COLA in minimum increments of $500 to the annual individual and catch-up contribution limits through 2010).  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 $20,000 maximum contribution limit less the tax due based on a rate of 35% [$20,000 (1-35%)], or $13,000.

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 2.1 Professional

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 $13,000 to $20,000.

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

Control Example 2 is flawed.  The comparison of outcomes resulting from a $20,000 contribution to both the pre-tax and the Roth account is not sound.  In this example, the contribution to the Roth account costs this participant $30,769, not $20,000, since the 35% tax on the $20,000 contribution is $10,769 [$20,000/(1-35%) = $30,769].  Therefore, an after-tax savings account, or "side fund," is established to invest the after tax proceeds of the $10,769, or $7,000 [($30,769 -$20,000) (1-35%) = $7,000]. 

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

Side Fund Contribution: $7,000 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%.

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 2.1 Professional

The Roth option is preferred if the individual's tax rate decreases to 28%, remains the same at 35% or increases to 42% at the time of distribution.

Reason for unanticipated outcome  The Roth provides the ability to invest in various asset classes within the 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 MTR Annuity Report (full report)

Available Estate Planning Opportunity  The previous examples established that the Roth is preferable for most high net worth business owners or highly compensated employees.  The examples that follow highlight the estate planning opportunity the Roth 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 or savings accounts until the year following the pensioner's death.  This means that the entire Roth account (and the after-tax side fund too) is paid to designated beneficiaries who elect to "super-stretch" 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 $220,000 the 2006 compensation limit), tax rate 35%.

Pre-tax Contribution: Maximum contributions for 5 years to a pre-tax account ($20,000 in 2006 subject to a 3% COLA in minimum increments of $500 to the annual individual and catch-up contribution limits through 2010).  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 $20,000 maximum contribution limit less the tax due based on a rate of 35% [$20,000 (1-35%)], or $13,000.

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 2.1 Professional

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 ($20,000 in 2006 subject to a 3% COLA in minimum increments of $500 to the annual individual and catch-up contribution limits through 2010).

Side Fund Contribution: $7,000 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%.

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 2.1 Professional

This example illustrates the Roth's retirement and estate planning opportunities.  The Roth effectively permits this individual to save more for retirement while providing the opportunity to postpone tax free distributions until the year following death.

View MTR "Super-stretch" Report (charts only report)

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 utilized.  Simply stated, the 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 generated by 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 for passing on a significant amount of assets to heirs 100% free of income tax?

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COLAs  After 2006, both the individual 401(k) and catch-up limits may each increase yearly in minimum increments of $500 based on cost-of-living adjustments (COLA).

Projected limits for 2007-2010 (assumes 3% COLA)

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