Many of your plan participants would greatly benefit from a Roth 401(K) provision. From the perspective of the plan sponsor, it’s a no brainer. It should be available on every plan. And you can enhance your plan benefits without one single penny of additional cost to the company.
Roth 401(k) provisions are grossly underutilized, and when available in a plan they are little understood by either participants or plan sponsors.
First introduced by The Economic Growth and Tax Reconciliation Relief Act of 2001 (EGTRRA), and subsequently made permanent in the Pension Protection Act in 2006 (PPA). Finally in 2010 the Small Business Jobs Act enabled conversions of existing 401(k) deferrals into Roth 401(k) accounts.
Traditional 401(k) employee deferrals generate a current tax deduction for the participant but are fully taxable when withdrawn, require mandatory distributions (MRD) beginning at age 70 ½, and may generate penalty tax for premature distribution.
The Roth feature turns that on its head. There is no tax deduction for contributions but distributions after five years and attainment of age 59 ½ are totally tax free. While distributions are required from the 401(k) at age 70 ½, the account may be directly rolled over into a Roth IRA and avoid any of those pesky minimum required distributions (MRD).
General Strategy Considerations
A Roth option gives the participant an opportunity to “leverage” the tax code to enhance after tax wealth.
- The rule of thumb is that if you expect to be in a lower tax bracket after retirement, then a traditional 401(k) deferral will maximize your after tax wealth.
- But, if you think your tax rates will be higher after retirement than when you make the contribution, the Roth 401(k) will benefit you.
- If you expect to be in the same tax bracket after retirement, then from an after tax wealth accumulation perspective it won’t matter.
So, if a participant is in their highest earnings years, a traditional 401K contribution probably works best for them. Deduct at high rates, and distribute at lower rates. Even if they never made a penny on their contributions they would come out ahead. Deferring taxes until you are in a lower bracket is always a good strategy.
But, some participants are beginning their careers and/or in a low tax bracket. The value of a current deduction after other adjustments to Federal Income Tax may be 0%, 10% or 12%. For those taxpayers, there is little or no reason not to consider the Roth option. Later they will most certainly enjoy zero tax distributions when they may be in a higher marginal tax rate. Tax free always feels good.
Other Strategy Considerations
- Given current and future expected US trillion dollar deficits, it’s certainly possible that tax rates may rise again sometime during your career and retirement. I wouldn’t want to bet against it. So, even some participants in high current marginal tax rates may wish to hedge their bets against even higher rates later by making Roth contributions.
- Wealthy participants that do not expect to have to use any or all of their 401(k) accumulations may wish to “pre-pay” their heirs income tax on 401(k) or IRA assets by converting some 401(k) accounts to Roth. Under current law, a properly done “Stretch” beneficiary designation will generate a tax free lifetime income for their next generation beneficiaries.
- Wealthy participants that expect to be subject to estate tax can instantly reduce their gross estates by the amount of any income tax paid on the conversion from regular to Roth. For those fortunate people this is a great estate planning opportunity.
In the real world simply adding an option to your company plan without providing the education to the employee group necessary for them to make good decisions won’t change many lives. Your investment advisor and/or Third Party Administrator (TPA) should support your employees with education, guidance and assistance so they can get the benefit.
Adding Roth 401(k) feature to your current plan should cost the company zero. Yet, it provides valuable flexibility for participants to maximize their wealth through an optimized tax treatment of their plan. There are still a huge number of plans that haven’t been updated in years. If your plan hasn’t incorporated Roth provisions perhaps now would be a great time to review it with a qualified professional.