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Effective January 1, 2006, the rules pertaining to 401(k) plans were modified by Congress to provide that if a 401(k) plan is so amended by the employer/sponsor, participants may designate their 401(k) salary deferrals as either regular, pre-tax 401(k) deferrals (“Regular Deferrals”) or “Roth” after-tax 401(k) deferrals (“Roth Deferrals”). Unlike a Roth IRA, 401(k) deferrals in a Roth 401(k) plan may be designated as Roth, after-tax deferrals regardless of the participant’s level of taxable income.
In the eyes of a participant and his/her financial advisor, the most difficult aspect of a Roth 401(k) plan is deciding whether it is better for a participant to pay income taxes up front on a Roth Deferral and receive the plan distributions (including the earnings) income tax free at retirement, or to reduce current income taxes by making Regular Deferrals and be fully taxable on the distributions at retirement.
There are a number of income tax, estate tax and other personal considerations that an individual should consider when deciding whether to treat his/her 401(k) deferrals as either Regular Deferrals or Roth Deferrals. Here are some of those considerations.
1. Tax Rates.
Given the fact that with a Roth Deferral, the participant pays income taxes up front on the amount of the deferral, but receives the entire distribution income tax free at a later date, a key factor to consider would be the relative tax rates at deferral and as of a projected retirement date. If a participant expects his/her income tax rates to rise over time, then the Roth Deferral is preferred. A young professional (such as a young doctor, lawyer or CPA) or an entry level employee might have this expectation and should strongly consider a Roth Deferral. Also, the U.S. government has been accumulating fantastic deficits over the last two decades, and one has to wonder when the day will come when the world economy forces us to raise taxes and pay down those debts.
Even if a participant is uncertain about whether income tax rates will rise, a Roth Deferral may constitute good planning from a “hedge” or “diversification” point of view. Participants who have been in qualified plans for a significant amount of time already have substantial amounts of pre-tax dollars in their accounts. A Roth Deferral can be a hedge against future increases in tax rates.
For those who are just beginning to make 401(k) deferrals, the Roth Deferral still can be a hedge against higher income tax rates in the future because employer matching and profit sharing contributions continue to be pre-tax contributions that will be taxed to the participant in the future.
2. Social Security Benefits.
Under current law, if an individual has taxable income above certain levels, such individual’s Social Security benefits become taxable, and therefore, the benefit is eroded. Since distributions of Roth Deferrals (and the income thereon) are not taxable, their distribution will have no detrimental impact on Social Security benefits.
3. Required Minimum Distributions.
As a general rule, when a participant attains age 70½ and retires, he/she must begin taking required minimum distributions (“RMD”) from a qualified retirement plan (like a 401(k) plan) and a regular IRA. An RMD is not required to be taken from a Roth IRA. Thus, a 401(k) plan participant interested in preserving his/her Roth dollars could roll over his/her Roth Deferrals (and the income thereon) to a Roth IRA and avoid taking an RMD at age 70½. This technique could be used to preserve the Roth Deferrals for another generation or it could allow the participant to continue to defer the receipt of those dollars until long after age 70½.
4. Forced Savings.
If a participant contributes to his/her 401(k) plan, the exact same amount of Regular Deferrals and Roth Deferrals, and invests them exactly the same, he/she will have the same amount in his/her Regular Deferral Account and Roth Deferral Account at retirement. The difference is that with the Regular Deferrals, the participant must pay income taxes on the distributions. Therefore, in order for the two accounts to remain equal even during the payout period, the participant must in a sense create a “side” savings account to accumulate the income taxes that are payable on the distribution of the Regular Deferrals.
By contrast, when the participant makes a Roth Deferral and pays his/her income taxes up front, the participant essentially has pre-paid or fully funded that “side” fund because no income taxes are due when the Roth Deferrals are distributed.
For those who might find it difficult to save for, and accumulate, that side fund to pay the income taxes due on the Regular Deferrals (because the temptation of a new car or boat is too great to save the tax money), the Roth Deferral may be an excellent mechanism to force the required tax savings. In a sense, the Roth Deferral can force the participant to save even more money currently because the participant is saving the deferrals and pre-paying the income taxes.
There is no one answer to the question of “To Roth or Not to Roth” that applies to every participant in a 401(k) plan. Each participant’s circumstances are different, as are their views of future tax laws and rates. As a result, it may be advisable to add a Roth Deferral feature to your 401(k) plan (assuming you have a say in your plan’s design), provide everyone with the necessary educational information about Regular Deferrals and Roth Deferrals, and then let each participant decide what to do.