Affluent Get Big Benefit From the Roth 401(k)

March 2006

Effective January 1, 2006, a Roth 401(k) option is available.  This Roth 401(k) option does not have the income limitations that have previously prevented use of Roth IRAs by affluent persons.  Employers with an affluent work force (such as law firms) should definitely be offering this option. 

Roth contributions, unlike pre-tax deferrals, are included in one's current taxable income.  In exchange for this current taxable treatment, Roth 401(k) earnings are tax-free when distributed so long as: 

1. The distribution occurs at least five years after the participant's first Roth contribution, and
2. The participant is at least 59 ½ years old, becomes disabled, or has died.

The Roth 401(k) option will require a simple Plan amendment and some additional recordkeeping obligations.  Compared to the benefits to your work force, this additional effort by the employer is definitely worthwhile.

For High Savers, the Popular Press is Wrong.

Non-affluent investors have to decide whether to reduce taxes currently, or accept the long-term advantage of not ever paying taxes on earnings in a Roth 401(k).  The affluent really don't have such difficult tradeoffs.    Consequently, the popular press on the Roth vs. regular 401(k) debate focuses on whether one's income tax rate is less in retirement than when the 401(k) contribution is made.  This leads one to the correct but overly simplistic conclusion that the benefit of a Roth vs. regular 401(k) depends on a comparison of the tax rates that exist now versus what will exist in retirement.

One problem with this comparison is that, when the Roth account has a long enough time to earn large returns, the ability to entirely escape taxes on earnings with a Roth account overcomes the fact that a smaller amount may initially be available to invest.

But a second problem occurs.  Most affluent professionals and business owners want to save far more for retirement than can be placed annually into a 401(k) account.  For these people, there is not a need to reduce one's 401(k) investment by the additional taxes that need to be paid currently if a Roth option is made.  For these affluent investors, additional retirement savings occur outside of the 401(k).

For anyone who is maxing out on their 401(k) contributions and/or has additional retirement savings outside the 401(k), then the answer proposed by the popular press is probably wrong, even if tax rates turn out to be lower during retirement.  Those who can afford to both save the annual 401(k) maximum and pay taxes now effectively get a near doubling (assuming a 50% marginal tax rate) of the annual limitations.  Stated otherwise, a Roth 401(k) effectively doubles the contribution limits that otherwise exist under IRC sections 402(g) or 415.

The Roth account is always better than the ordinary savings that are outside any 401(k).  This occurs because the same rate of return, when non-taxed, is always better than giving some of your earnings to the government.  Since the money earned inside a Roth account is tax free, the after-tax return of the Roth savings will always beat the alternative of having some of your retirement savings in a currently taxable account.

This conclusion may not be true for savers who are not maxing out on their 401(k) contributions, especially if the employer is matching employee contributions.  If one reduces the amount contributed to a Roth 401(k) to pay for current income taxes, the "free" money provided by the employer's matching contribution might also be reduced.  In this circumstance (which rarely applies to affluent professionals and business owners anyhow), the regular 401(k) account may be best.

Other Reasons Why Affluent Benefit Extra from the Roth 401(k)

As explained above, the Roth account effectively increases one's tax-advantaged investments.  In addition, affluent professionals, executives and business owners should generally be using a Roth 401(k) for the following reasons:

1. More affluent people are more likely to remain in the higher tax brackets during their retirement, thus favoring the Roth account under the traditional, simplistic analysis.  Moreover, because of America's growing social welfare obligations for Medicare and Social Security, combined with the already high federal deficits, it is unlikely that there will be lower taxes in the future for the affluent.  A real possibility exists for higher marginal tax rates in the future, creating an advantage for paying taxes on retirement funds now.
2. Because 401(k) plans are exempt from creditor claims, a 401(k) plan is the best and least expensive asset protection device available.  In the unfortunate situation that lawsuits or other tragedies cause such planning to be applicable, a Roth 401(k) effectively doubles the after-tax monies that are safe from creditors.
3. If you are classified as a "highly compensated employee", or HCE and your contributions are limited because the Plan otherwise fails the anti-discrimination tests, a Roth contribution effectively gets the HCE the same after-tax result within the smaller limits that are allowed.
4. Because regular 401(k) distributions are part of the income base used to determine whether Social Security benefits are taxed, the Roth account does not worsen the challenge of keeping Social Security benefits from being taxed.
5. A Roth 401(k) can be rolled over to a Roth IRA, which does not have minimum distribution requirements during the life of the IRA holder.  By using the Roth 401(k) and making this rollover, those with substantial retirement savings can avoid the requirement to take 401(k) withdrawals at age 70 ½.  This is important to anyone interested in leaving tax-advantaged money to the next generation.

The IRS has now published its Roth 401(k) regulations, so there is no good reason for employers to delay this sound choice.  The additional recordkeeping and administrative costs are small compared to the benefits described above.  The deadline to adopt an amendment implementing Roth provisions is the end of the plan year in which the Roth amendment is effective.

Fulcrum Inquiry is a Registered Investment Advisor and a licensed CPA firm.  We help law firms with a broad range of financial services that help lawyers serve their clients, such as damages analysis, financial investigations, and appraisals of business interests.