There were more than 400 new tax rules in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and most went into effect years ago. But the time is finally arriving for one provision that will substantially alter the retirement plan market. It’s the Roth 401(k), and after a sustained period in which Americans have accumulated trillions of dollars in retirement assets through traditional 401(k) plans that will inevitably be taxed, the Roth option, which will be available January 1, 2006, opens the door to tax-free retirement income.

While the Roth 401(k) will hold appeal for millions of investors, perhaps no group will be more interested than high-income earners and proprietors of owner-only businesses. In addition to tax-free retirement income, it’s a highly effective estate planning tool, potentially helping to stretch assets and minimize taxes for decades.

The Roth 401(k) is similar to the Roth IRA in that it allows after-tax contributions to fund tax-free retirement income. However, the new Roth 401(k) rules allow for sharply higher annual contribution amounts than the Roth IRA–up to $20,000 in the 2006 tax year versus just $5,000 for the Roth IRA. Moreover, unlike the Roth IRA there are no income limits on investors who want to make Roth 401(k) contributions. Under current regulations, Roth contributions can be made to a new or existing 401(k) account, either as a substitute for or complement to pre-tax contributions.

Why might advisors look closely at this valuable new opportunity for proprietors of owner-only businesses? Simply put, the combination of high contribution limits and tax-free income could shift the balance in their effort to successfully prepare for retirement. Of the more than 65% of business owners who say the business is their primary source of income, nearly one third are over age 55. According to the Small Business Administration, small business owners are among those most likely to overlook retirement planning, in many cases resting their hopes on the sale of their businesses to fund their long-term financial needs.

Thanks to earlier provisions of EGTRRA, proprietors of owner-only businesses have had the option of establishing an owner-only 401(k) plan since 2002. These plans offer a potentially attractive alternative to traditional sole proprietor plans, particularly for business owners who can afford to set aside large amounts of money for retirement.

Operating like a large corporate 401(k) plan–but with lower costs and fewer administrative requirements–an owner-only 401(k) plan allows the business owner as “employee” to defer up to $15,000 of earned income in 2006. Individuals age 50 or older can make another $5,000 in so-called catch-up contributions.

In addition, the “employer” can make tax-deductible contributions of up to 25% of the employee’s earned income. In total, employer and employee annual contributions can reach as high as $47,000 or 100% of earned income. Contributions are not required in any given year, and unlike with SEP-IRAs, business owners may take tax- and penalty-free loans from the account — the lesser of $50,000 or 50% of their account balance.

Beginning January 1, 2006, EGTRRA’s Roth 401(k) provision allows business owners to direct either a portion or all of their employee deferrals to an account established to provide tax-free income in retirement. The difference with these contributions is that they will be made in after-tax rather than pre-tax dollars. Roth contributions are irrevocable; once they are allocated to a Roth 401(k) account, they cannot be shifted to a pre-tax account. The tax-deductible employer contributions will continue to be made to the pre-tax account.

“Qualified”–i.e., tax-free–distributions will be allowed only in the cases of death, disability, or attainment of age 59 1/2 as long as it has been at least five years since the initial Roth 401(k) contribution was made. Finally, Roth 401(k) accounts can be rolled into other Roth 401(k)s or Roth IRAs.

The Role of Taxes

Taxes play a key role in determining whether a Roth 401(k) is appropriate for any particular investor. The Roth 401(k) will almost always result in less tax paid due to the vehicle’s tax-free earnings, especially if the account is held for a long period of time and achieves significant gains. In assessing whether a Roth 401(k) may be right for an investor, many people focus on the impact of future tax rates at retirement. However, high-income earners who maximize contributions under Roth will receive greater after-tax retirement income.

Let’s consider the effect of changing tax rates at retirement in a scenario comparing a traditional pre-tax contribution with a Roth 401(k) contribution, with no employer contributions. These hypothetical calculations exclude standard deductions and personal exemptions, assume no withdrawals from the account prior to retirement, and no tax law changes.

The investor has $20,000 to invest in his retirement account and is subject to 28% federal tax rate. Therefore, he decides to invest the full $20,000 in the pre-tax account or $14,400 in the Roth account ($20,000 minus $5,600 in federal taxes). Each account earns a hypothetical 8% annually during the accumulation phase, which lasts 20 years. The balance in the pre-tax 401(k) plan after 20 years would be $93,219, while the Roth 401(k) balance would be $67,118.

  • If tax rates at retirement remain steady at 28%, the net proceeds from both accounts are equal at $67,118.
  • If the tax rate falls to 23% at retirement, the net proceeds of the pre-tax account are $71,779, greater than the Roth account.
  • But if tax rates rise to 33%, the pre-tax account leaves the investor with $62,457, less than the Roth account.

Therefore an investor benefits from pre-tax contributions if tax rates fall at retirement, but if tax rates rise, they are better off with the Roth 401(k).

However, note that in all three scenarios, the $5,600 paid in taxes on the Roth 401(k) contributions was significantly less than the taxes paid at distribution in the pre-tax 401(k) account.

Now let’s take the same scenario and assume that the investor wants to maximize her contribution to the plan. The table above assumes that taxes due on the Roth 401(k) contribution are paid from another source and do not reduce the contribution amount. In this scenario, Roth results in a larger distribution regardless of tax rate changes, even if tax savings on the pre-tax contribution are invested separately.

This scenario appeals to high-income earners who can afford to contribute the maximum to their 401(k) plan and absorb the tax cost outside of the plan, which is why Roth may be most appealing to these investors.

The impact of future tax rates is difficult for an investor to evaluate because it depends upon federal tax rate changes and their own personal future income. However, the Roth 401(k) can help to diversify retirement portfolios and hedge against possible rising tax rates. Roth contributions to a 401(k) plan may be an appropriate choice for proprietors of owner-only businesses and high-income earners who want to maximize their retirement contributions even on the chance that rates remain at their current, historically low levels.

Benefits and Sunsets

Whether it’s for a business owner evaluating retirement plan options or a high-income earner considering tax-advantaged retirement programs, the Roth 401(k) offers numerous potential advantages.

Consider first how the Roth 401(k) might complement a retirement investing strategy already in place using either an owner-only 401(k) plan or a SEP-IRA. For example, by splitting contributions between a pre-tax and a Roth account, a business owner can reduce tax obligations now and plan for tax-free income in the future. The owner-only 401(k) plan is the only plan type that allows Roth and pre-tax contributions. Total contributions are also higher using an owner-only 401(k) plan than with a SEP-IRA.

For example, consider the case of a 55-year-old proprietor of an owner-only business with $100,000 in W-2 income. With a SEP-IRA, he or she would be able to contribute a maximum of $25,000 to his account. In the owner-only 401(k), he or she could contribute $20,000 to his Roth account and another $25,000 to his pre-tax account, for a total contribution of $45,000.

All of the more than 400 provisions of EGTRRA–including the Roth 401(k)–expire after December 31, 2010, unless they are extended by Congress. If Congress takes no action, investors will not be permitted to make contributions after that date, but any money held in Roth 401(k) accounts at that time can continue to grow, and qualified, tax-free distributions will be permitted on an ongoing basis.

What does this mean for investors? At a minimum, today’s high-income earners and owner-only businesses have a five-year window to take advantage of this valuable opportunity and contribute as much as possible to a Roth 401(k). As the table above shows, making the maximum contribution, even during this relatively brief period, can potentially pay off over time.

Today’s high-income earners and proprietors of owner-only businesses face a number of competing financial priorities, including tax management and retirement and estate planning. Regardless of whether the sunset provisions take effect as scheduled or whether tax rates rise in the future, these investors have at least five years in front of them to take advantage of this new tool to diversify their retirement portfolios and accumulate wealth.

Adding Roth contributions to an owner-only 401(k) can potentially become a sole proprietor’s winning strategy for long-term success. The combination of employer and employee contributions will allow the business owner to maximize investment dollars to both accumulate a nest egg for tax-free income and prepare to pass along a valuable and lasting tax-free legacy to heirs.

Christopher G. Laucks, CFP, is VP, retirement and annuity markets for Pioneer Investments in Boston. He can be reached at chris.laucks@pioneerinvest.com.