WealthManagement Magazine

A Friendlier 401(k)

When Congress created the Roth 401(k) back in 2001, hardly anyone, including your clients, probably noticed or even cared. Financial advisors and investors were far more excited about the other goodies that the 2001 tax act delivered. However, it's probably time for everyone to sit up and take notice. Beginning in January, workplaces can begin offering a Roth 401(k) alongside traditional 401(k) plans.

When Congress created the Roth 401(k) back in 2001, hardly anyone, including your clients, probably noticed or even cared. Financial advisors and investors were far more excited about the other goodies that the 2001 tax act delivered.

However, it's probably time for everyone to sit up and take notice. Beginning in January, workplaces can begin offering a Roth 401(k) alongside traditional 401(k) plans. How many investors and employers will embrace this latest way to save for retirement remains an open question, but the Roth offers numerous benefits for the right clients.

For advisors, too, there are benefits. “Brokers can use the Roth 401(k) as a door opener for new business opportunities,” says Barry Milberg, a pension compliance expert and founder of ERISA Expertise in Blue Bell, Pa., which has developed a series of Roth 401(k) tools for advisors, employees and plan service providers.

The Candidates

Among the investors who will benefit most from the Roth 401(k) are affluent Americans, who have always been excluded from the Roth IRA party. A married couple filing a joint tax return is prohibited from contributing to a Roth IRA if their adjusted gross income exceeds $160,000. A single person's adjusted gross income can't exceed $110,000. The Roth 401(k), however, makes no income distinctions.

Entry-level employees and others making modest salaries could also be thrilled with the Roth 401(k). And here's why: During recent years, the tax code has obviously grown more generous. Standard deductions, tax credits and large personal exemptions have wiped out federal income taxes for some low and middle-income households. A married couple making $40,000 with two children, for example, would have paid no federal taxes in 2004. Getting an upfront tax break for contributions into a traditional 401(k) won't mean anything if someone's tax bill is nil. Better to stuff the money in a Roth IRA or Roth 401(k).

Ed Slott, a CPA in Rockville Centre, N.Y., and the author of two IRA books, including Parlay Your IRA Into a Family Fortune (Viking, 2005), goes so far as to suggest that maxing out a Roth 401(k) first makes sense for every worker. “I'm a big fan of getting as much money in a Roth as possible, and the Roth 401(k) puts the pedal to the metal,” Slott observes.

More Money to Hide

For wealthy clients, the Roth 401(k) is a way to shelter more money. Suppose a person in the 35 percent federal tax bracket makes a $20,000 contribution to a Roth 401(k). This contribution equals a $30,769 contribution to a pretax account, Milberg says. The new Roth option could also make affluent investors a bit less reliant on conservative municipal bonds, he suggests, “The Roth 401(k) provides a very attractive alternative to tax-free investing as compared to traditional tax-free investments such as tax-free bonds.”

Still, before drawing any conclusions about the Roth 401(k), you'll have to understand how this new retirement hybrid, which combines aspects of an IRA with a workplace plan, works.

For starters, a company can offer the traditional 401(k) as well as the Roth newcomer. The Roth 403(b) is also available for workplaces sponsoring the traditional 403(b). Employees can feed both of them, but the combined contributions can't exceed the maximum limit on either. A worker who is at least 50 years of age in 2006 can contribute up to $20,000, including the $5,000 catch-up provision, to either of the 401(k) plans or a combination. Younger workers can shelter a maximum of $15,000. Workers can split their contributions anyway they'd like between the 401(k) accounts.

Unlike 401(k) contributions, the money that's earmarked for a Roth 401(k) will be taxed upfront. Consequently, if an employee desires the same net take-home pay that he enjoyed with a traditional 401(k), he'll have to make lower Roth workplace contributions. As with regular 401(k) contributions, money diverted into a Roth 401(k) will also be subject to Social Security and Medicare (FICA) taxes.

The rules for the Roth 401(k) distributions also differ. Because the tax pain is felt upfront, qualified distributions avoid income taxes. To be considered qualified, a distribution must jump two hurdles. First, money can't be withdrawn tax-free unless the employee is at least 59 1/2, becomes disabled or dies. An employee must also have kept money in the Roth 401(k) for five years.

The new 401(k) does arrive with some irritating ticks. Perhaps the biggest is its uncertain shelf life. The legislation that created the Roth 401(k), as well as many other 2001 tax breaks, is scheduled to expire at the end 2010. If that happens, investors could roll their workplace Roths into a regular Roth IRA when they quit or retire. Until then, the cash would stay in the Roth 401(k) — it just couldn't accept new contributions.

Be Not Afraid

Uncertainty about its longevity, however, shouldn't prevent investors from taking advantage of the new plan, says Lori Lucas, the director of participant research at Hewitt Associates, an employee benefits consulting firm in Lincolnshire, Ill.

“I don't see any downside to putting money in a Roth 401(k), even with the sunset,” she says. “Workers would have the ability to contribute 401(k) money into a tax-free vehicle and it would be grandfathered in.”

What's also unclear is how many employers will roll out the new 401(k). Hewitt Associates conducted a survey late last year that revealed 35 percent of employers are very or somewhat likely to launch a Roth 401(k). Many of the corporate trailblazers that intend to offer the new 401(k) next year, Lucas says, are in the financial services industry, or are companies with financially savvy employees.

The new Roth retirement plan has the potential to expand a broker's business. “If you are prospecting, the Roth 401(k) could be a door opener,” says Thomas Lanahan, who is president of 401kQuote.com, which is a retirement plan consulting firm that specializes in evaluating retirement plans. The key is selling a corporation or business owner on the merits of this latest retirement plan, Milberg says. “The broker should focus on the business owner. That's who the Roth, hands down, very clearly benefits.”

If you are already selling workplace retirement plans, you need to educate the employers on the intricacies of the Roth 401(k), Lanahan says. In addition, you can share information with employees about the Roth 401(k) when you hold annual or semiannual educational meetings.

Meanwhile, plan vendors will be doing the heavy lifting by developing record keeping for the new Roth. Many vendors are also developing software that will help workers decide whether they should embrace their newest workplace option.

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