From the Editor
To ® or Not to Roth ?
ven with a crystal ball, Hamlet would have had difficulty with this
Lone . Starting next year, employers will have the option to add a
Roth contribution feature to their 401(k) and 403(b) plans . (For convenience, I will refer to both as Roth 401(k)s .) At least some employees might reap considerable tax advantages from making Roth, rather
than regular, 401(k) contributions . What is much less clear is whether
that possibility is worth an employer's taking on the expense and
communication and administrative hassles of setting up the new pro gram-not to mention the risk that some befuddled employees will
act against their best interests .
The Basics
Under new Internal Revenue Code (IRC) Section 402A, employers
can amend their 401(k) plans to allow employees to designate all
or a portion of their voluntary contributions as Roth contributions .
The income limitations do not apply to Roth 401(k)s, so even folks
earning above $110,000 ($160,000 for joint filers) can make Roth
401(k) contributions . Roth contributions are made after-tax, but
qualifying Roth 401(k) distributions, including earnings, are tax-free .
The conditions to tax avoidance are a five-year holding period (from
the date of the first Roth contribution) and distribution only at or after
age 591/2, or upon death or disability .
0therwise, Roth and regular 401(k) contributions are treated
similarly: both are covered by the IRC Section 402(g) and 415
contribution limits, average deferral percentage (ADP) testing and
hardship, age 701/2, and other distribution rules . However, Roth 401(k)s
can only be rolled over to another- Roth 401(k) or a Roth IRA . Since
Roth IRAs are not subject to the age 701/2 minimum distribution rules,
employees may be able circumvent the 401(k) minimum distribution
rules by rolling over their Roth 401(k)s to Roth IRAs . Further IRS
guidance is needed to confirm that approach .
When Are Roth 401(k)s Better?
The short answer is that Roths trump regular 401(k)s if the employee
is in a lower marginal tax bracket at the time of contribution than
he or she will be at retirement. If the employee's tax rate does not
change, there generally will be no economic difference, and if the
employee's tax bracket will be lower in retirement, regular 401(k)s
will be a better deal than Roth 401(k)s. The employee's investment
return does not affect the result . I will spare you the mathematical
calculations, but the rile of thumb is that the benefit or detriment o f
BENEFITS LAW JOURNAL
1
VOL . 18, NO . 3, AUTUMN 200 5
"This article was republished with permission from Benefits Law Journal, Vol . 18, No. 3, Autumn 2005), Copyright 2005, Aspen Publishers, Inc . All rights reserved . For more information on
this or any other Aspen publication, please call 800-638-8437 or visit www .aspenpublishers.com."
From the Edito r
the Roth over regular 401(k) contributions equals the difference in tax
rates multiplied by the amount that will be distributed .
The difficulty, of course, is that an employee's future tax rate is
impossible to forecast . What other forms of retirement income will
the employee have? Will the deficit force Congress to raise tax rates at
some future date? Will Congress approve a flat tax, consumption tax, or
other new system? Will Congress decide to impose additional taxes on
retirement accounts that are too large (remember IRC Section 4980A)?
What will be the employee's state and local tax obligations? Not to
mention the possibility that Congress will fail to extend the Roth tax
rules when they are scheduled to expire in 2010 . You get the picture .
The analysis is actually even more complicated because, under the
current tax code, many employees have a "moving" marginal tax rate .
For example, an employee with income above $319,100 and filing a
joint return is in the 35 percent bracket, but the employee's marginal
rate can be higher due to the phase outs of personal exemptions (for
income between $218,950 and $343,950) and itemized deductions
(for income above $149,950) . [Note : starting in 2006 these phase-outs
are scheduled to start being phased out themselves .] Then there is the
alternative minimum tax (AMT), which also can bump up effective tax
rates . Thus, higher earners (the very employees most likely to benefit
from a Roth) need to calculate their average marginal rate based on
income, number of dependents, and type and amount of itemized
deductions.
Though tax rates drive the Roth versus non-Roth analysis, the
employee must also determine whether the additional up-front taxes
on any Roth contributions would be paid through reduced plan
contributions, reduced savings outside the plan, or a cut in spending .
For example, say an employee with a 30 percent marginal rate
can afford to save only $10,000, gross . That employee could either
contribute $10,000 as a regular 401(k) or $7,000 as a Roth 401(k)
contribution . If the 401(k) plan has an employer match, the employee
must consider whether, and how much, the plan would match the
$3,000 differential . In most, if not all, cases, maximizing the employer
match will make regular 401(k) contributions the better choice .
But what if the employee currently is saving in both a 401(k) plan
and in taxable investment accounts, and would finance the added
taxes from switching to Roth 401(k) contributions by reducing his or
her savings outside of the 401(k) plan? In that case, the employee
must also consider that the tax rate on any investment earnings on
the non-401(k) money will vary depending on the type of investment .
Municipal bonds would provide tax-free interest ; equities, dividends,
and capital gains would be taxable at a reduced 15 percent rate and
allow offsetting losses against gains, while corporate bonds, CDs, etc .
would be taxed at the highest rates .
Some employees may use the Roth 401(k) to increase their savings
rate . These employees, perhaps needing the discipline of automati c
BENEFITS LAW JOURNAL
2
VOL . 18, NO . 3, AUTUMN 2005
From the Edito r
payroll withholding, would continue to contribute the same amount
to a Roth as they would with a regular 401(k), financing the added
up-front taxes through reduced spending .
Other factors to consider are the possibility of rolling Roth 401(k)
contributions to a Roth IRA, potentially avoiding the minimum distribution rules, and making both regular and Roth 401(k) contributions .
Having both types of accounts would allow employees to choose the
source of their withdrawals in retirement, based on their particular
tax situation that year, say to avoid taxes on Social Security income
or the AMT.
Employer Issues
Employers will be faced with a different set of considerations in
deciding whether to add a Roth feature to their existing 401(k) plans .
First off, the administrator must be able to provide the necessary
recordkeeping, and payroll must be capable of accommodating the
added reporting. Employers with trouble passing the ADP test will
need to guess what effect adding a Roth 401(k) feature would have
on employee contributions, such as whether nonhighly compensated
employees will reduce their contributions to finance the added tax
burden--or will information overload lead some to simply forgo
contributions altogether .
A significant challenge to employers who decide to add a Roth
401(k) feature is effectively communicating the highly complex
considerations and assumptions that go into choosing between a
Roth and/or regular 401(k) contribution . I'm doubtful that employers
will be able to clearly explain to even well-educated participants the
myriad tax and financial factors involved . And, even those employees
willing and able to distill all of these variables must still correctly
predict their future tax situation.
Of course, employers can "simply" list the rules and advise
employees to consult their tax advisor-except that most employees
do not have a tax advisor or, if they do, often do not seek or take his
or her advice. Another concern is that employees whose sole financial
planning goal is paying as little tax as possible will automatically
opt for a Roth, even if it is against their economic interests . This
situation crops up on a regular basis when executives are offered
the opportunity to participate in a deferred compensation plan, and
I would expect the problem would only be compounded in a broadbased 401(k) plan .
A final concern is that in a few years, Congress may decide to
eliminate Roth 401(k)s. I do not think distributions from existing
Roths would be made taxable-that would be political suicide-but
that legislators could prohibit further Roth contributions, leaving
employers to administer hundreds of relatively small, frozen accounts
for decades .
BENEFITS LAW JOURNAL
3
VOL . 18, NO . 3, AUTUMN 2005
From the Edito r
To Roth or Not to Roth ?
Clearly some employees would be better off making Roth 401(k)
contributions (and others may clamor for the right to do so) . But
for most employers, adding a Roth feature to their 401(k) plans will
not be worth the communication difficulties, recordkeeping, and
admin costs and hassles and risk that some employees will snake
wrongheaded choices .
The most likely candidates to benefit from adding a Roth 401(k)
feature are employers with a sophisticated, high-paid workforce, like
large law, accounting, and financial firms--probably not the group the
late Senator Roth and his colleagues had in mind when they tinkered
with the tax code .
David E. Morse
Editor- in-Chief
Kirkpatrick & Lockhart Nicholson Graham LLP
New York, NY
BENEFITS LAW JOURNAL
4
VOL . 18, NO . 3, AUTUMN 2005