Assessing the Roth 401(k)

By now you’ve probably started to think about the new Roth 401(k), which begins on January 1, 2006. Part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Roth 401(k) plans are getting more attention as firms and individuals think about their potential value. The Internal Revenue Service proposed regulations for the new plans in March and is still soliciting comments. But it may be worth spending some time considering the implications of the Roth 401(k) so that you are ready to go when regulations are final. This is very time sensitive since the entire EGTRRA is scheduled to end after 2010, unless Congress acts to extend it.

For advisors there are two key issues. First, is there an opportunity to use this for your own firm, and, second, how could it work for your clients? The process of analyzing whether the Roth 401(k) is beneficial for your own firm’s employees could help you work out your method for evaluating the Roth 401(k) for clients.

Another challenge that advisors will face is how to effectively communicate with employees and clients regarding the differences between a traditional 401(k) and the Roth version. The rules for the Roth 401(k) look similar to those for the Roth IRA, but there are some important differences. In a Roth 401(k), income taxes are paid at participants’ regular income tax rates at the time of contribution, and earnings and withdrawals are not taxed if withdrawals begin after age 591/2 and if five years have elapsed from the date of the first contribution to the plan. Taxes and penalties are waived if a participant dies or is disabled. Participants must take minimum distributions beginning the year after they turn 701/2. A Roth 401(k) can be rolled into a Roth IRA if the participant leaves the company, relieving the participant from taking minimum distributions–a noteworthy planning option.

If you now offer a 401(k) for yourself and your employees, adopting the Roth plan may be a tremendous chance for you and your employees to add to retirement savings, because even those who are ineligible because of income caps for the Roth IRA can contribute to the Roth 401(k). In terms of your employees, with a Roth 401(k), a participant can save up to $15,000 in contributions for 2006, plus another $5,000 in catch-up contributions if they turn 50 or older in that year.

For a quick, back-of-the-envelope example, say you turn 50 in 2006 and are in the 33% federal tax bracket. Let’s assume that your company allows you to max out your 401(k). You have a chance to save $15,000 in a Roth 401(k), plus another $5,000 catch-up contribution because you are 50 or older that year. Remember, these are after-tax contributions, so you would have paid $6,600 in federal income taxes on that $20,000 in income. (We are not addressing state or local taxes).

If you max out your contributions for the five years the Roth plan is scheduled to run, you have $100,000 in contributions in your Roth 401(k), and have already paid the taxes on that amount. You will owe no taxes on qualified withdrawals, and if you have invested wisely, the Roth 401(k) has grown.

The tables on below provide two examples of how a 50-year-old could invest $20,000 annually in a Roth 401(k). Table 1 assumes that you make regular monthly contributions for five years to a Roth 401(k) starting in January 2006. Table 2 assumes that you contribute $5,000 to a Roth 401(k) on January 1, 2006, and add $5,000 at the beginning of each quarter for five years.

For a younger person making less money, the effect is no less dramatic because of the longer time horizon. Even if someone participates only for the five years that the Roth 401(k) is scheduled to be available under EGTRRA, the option of after-tax contributions and tax-free withdrawals could add considerable value to the total retirement picture.

Corrected tables: Tables in this article published in the July 2005 issue of Investment Advisor contained data that showed results as if one had made periodic (monthly or quarterly) contributions to a Roth 401(k) for 20 years, (as if the Roth 401(k) is allowed to continue and there were no sunset provision in EGTRRA) instead of contributions only for the five years that the Roth 401(k) currently is scheduled to run before planned sunset provisions end EGTRRA, including the Roth 401(k).