An Analysis of the New Roth 401(k)/403(b) Plans

EXECUTIVE SUMMARY

• Under a qualified Roth contribution program, an individual can elect to make “designated Roth contributions” in lieu of all or a portion of pretax elective deferrals that the individual is otherwise eligible to make under the 401(k)/403(b) plan.
• Contributions to a Roth 401(k) account are made with after-tax dollars, and qualified distributions from an account are not includible in gross income.
• The ordering rules in Sec. 408A(d), which apply to nonqualifying distributions from Roth IRAs, do not apply to nonqualifying distributions from a designated Roth account.
• Roth 401(k) accounts are subject to required minimum distribution rules; however, eligible distributions from an account can be rolled over into a Roth IRA.

The Roth 401(k)/403(b) provisions, effective for tax years beginning on or after January 1, 2006, combine characteristics of Roth IRA and traditional 401(k)/403(b) plans in one retirement program. Under the new provisions, employee contributions to a Roth 401(k)¹ plan can be made in the same dollar amount as under a traditional 401(k)/403(b) plan. Unlike a traditional plan, the contributions are not excludible from gross income; however, similar to a Roth IRA, qualified distributions from a Roth 401(k) plan are tax free and not includible in gross income. The new provisions were set to expire for tax years beginning after 2010; however, the Pension Protection Act of 2006, P.L. 109-280 (PPA ’06), repealed the sunset provision as it applied to pensions and IRAs, thereby making the Roth 401(k) provisions permanent.

Overview

Under Sec. 402A, a 401(k)/403(b) plan can include a qualified Roth contribution program. This permits an individual to elect to make “designated Roth contributions” in lieu of all or a portion of pretax elective deferrals that the individual is otherwise eligible to make under the 401(k)/403(b) plan.² Designated Roth contributions are treated as elective deferrals for purposes of Chapter 1 of the Code (i.e., normal income taxes and surtaxes) and are allowed in the same dollar amount as employee contributions under a 401(k)/403(b) plan. For 2008, the maximum contribution is $15,500, or $20,500 for individuals over age 50 using the catch-up limit.³ These contributions are significantly higher than the maximum contribution to a Roth IRA for 2008 of $5,000, or $6,000 for an individual over age 50.⁴ Although treated as elective deferrals, a major difference between designated Roth contributions and employee contributions under a 401(k)/403(b) plan is that designated Roth contributions are made with after-tax dollars and are not ex-cludible from gross income.⁵

The Roth 401(k) rules have no effect on any company matching dollars under an individual’s 401(k)/403(b) plan; thus, employer matching is with pretax money and goes into the individual’s traditional 401(k)/403(b). Employers must maintain separate accounts (designated Roth accounts) for the designated Roth contributions, including any earnings allocable to the contributions, and must maintain separate recordkeeping with respect to each designated Roth account.⁶

Designated Roth contributions will receive tax-free growth treatment similar to Roth IRA contributions; however, unlike Roth IRA contributions, designated Roth account contributions are not subject to the Roth IRA adjusted gross income (AGI) limitation under Sec. 408A(c)(3)(A). This limitation prevents many higher-income individuals from being able to contribute to a Roth IRA. For instance, Roth IRA contributions are not allowed in 2008 when modified AGI is more than $169,000 if married filing jointly, $10,000 if married filing separately, and $116,000 for all other taxpayers.⁷

Due to the absence of the AGI limitation for designated Roth contributions, if an employer offers employees the option within its 401(k)/403(b) plan of making designated Roth contributions, all employees can make contributions. Thus, a larger group of individuals, including higher-income individuals, will be eligible to contribute to Roth 401(k) plans as compared with a Roth IRA.

For higher-income individuals, the Roth 401(k) is extremely attractive, offering tax-free growth similar to a Roth IRA and higher contribution limits. For an individual that currently has a Roth IRA, the Roth 401(k) is attractive in that it provides an additional Roth investment offering a significant increase in the amount of money the individual can put into Roth plans, namely $5,000 into a Roth IRA and $15,500 into a Roth 401(k).

The Roth 401(k) benefits of in-creased contributions and no AGI limitation do come with a significant tax cost. As mentioned previously, although designated Roth contributions are treated as elective deferrals, such contributions are not excludible from gross income. As a result, contributions made to the designated Roth account are made with after-tax dollars, unlike employee elective deferrals under a traditional 401(k)/403(b) plan, which are made with pretax dollars. The additional tax cost of contributing $15,500 to a Roth 401(k) rather than a traditional 401(k)/403(b) ranges from $2,325 ($15,500 × .15) for an individual in a 15% tax bracket to $5,425 ($15,500 × .35) for an individual in a 35% bracket. This additional tax cost is an important factor to consider in deciding whether to contribute to a Roth 401(k) versus a traditional plan. Before contributing to a Roth 401(k), an individual must verify that the Roth benefits outweigh the cost of currently paying additional yearly taxes. The major benefits of a Roth 401(k) will now be addressed.

Qualified Distributions

The most significant benefit of a designated Roth account is that qualified distributions are not includible in gross income.⁸ The term “qualified distribution” has almost the same meaning as under the Roth IRA rules. A qualified distribution from a designated Roth account is one that is (1) made on or after the date on which the individual attains age 59½, (2) made to a beneficiary (or to the estate of the individual) on or after the death of the individual, or (3) attributable to the individual’s being disabled.⁹ If a qualified distribution consists of employer securities, the individual’s basis in the securities is their fair market value at the time of distribution.¹⁰

Caution: First-time homebuyer distributions that qualify as special purpose distributions under the Roth IRA rules do not qualify as tax-free distributions from a designated Roth account.¹¹

A distribution is not a qualified distribution if made within the five-tax-year period beginning with the earlier of (1) the first tax year for which the individual made a designated Roth contribution to any designated Roth account established for that individual under the same applicable retirement plan, or (2) if a rollover contribution was made to the designated Roth account from a designated Roth account previously established for that individual under another applicable retirement plan, the first tax year for which the individual made a designated Roth contribution to such previously established account.¹² The plan administrator or other designated party for the 401(k)/403(b) plan is responsible for keeping track of the five-tax-year period.¹³ If a lump-sum nonqualifying distribution consists of employer securities, the net unrealized income thereon is (1) not includible in income, (2) not included in the basis of the securities, and (3) capital gain when realized in a subsequent taxable transaction.¹⁴

Nonqualifying Distributions

A nonqualifying distribution from a designated Roth account is treated much differently than one from a Roth IRA. Specifically, the ordering rules in Sec. 408A(d), which provide that the first distributions from a Roth IRA are a nontaxable return of contributions until all contributions have been returned, do not apply to nonqualifying distributions from a designated Roth account. Nonqualifying distributions from a designated Roth account are taxable under Sec. 402 in the case of a 401(k) plan and under Sec. 403(b)(1) in the case of a 403(b) plan.¹⁵

For this purpose, a designated Roth account is treated as a separate contract under Sec. 72.¹⁶ Thus, if the nonqualifying distribution is made before the annuity starting date, the amount includible in gross income as an amount allocable to income and the amount not includible in gross income as an amount allocable to investment in the contract are determined under Sec. 72(e)(8). For nonqualifying distributions on or after the annuity starting date, the amounts are determined under Sec. 72(b).

For instance, assume that an individual, before the annuity starting date, takes a nonqualifying distribution of $10,000 from a designated Roth account with a value of $25,000. Also assume that the individual previously made contributions of $20,000 to the account (thus, $5,000 of the account value is earnings). The amount includible in income is $2,000 ($5,000 ÷ $25,000 × $10,000), and the amount not includible in income is $8,000 ($20,000 ÷ $25,000 × $10,000).

Minimum Distribution Rules

A significant benefit of a Roth IRA is that distributions are not required at any age because distributions are not subject to the required minimum distribution (RMD) rules. Designated Roth account distributions are not afforded this benefit and are subject to the same RMD rules as traditional 401(k)/403(b) plans. These RMDs must start by April 1 of the calendar year following the later of (1) the calendar year the individual attains age 70½, or (2) the calendar year in which the individual retires. Any RMDs taken from a Roth 401(k) plan would, of course, reduce the benefit of future tax-free growth.

Fortunately, an individual can escape the minimum distribution rules by rolling over a Roth 401(k) into a Roth IRA. A designated Roth account dis-tribution can be rolled over into another designated Roth account or a Roth IRA,¹⁷ and the amount rolled over is not currently includible in gross income.¹⁸ In the case of a rollover into a designated Roth account, the rollover must be accomplished through a direct trustee-to-trustee transfer to the extent of any portion of the distribution not includible in income.¹⁹ Although a 60-day rollover to another designated Roth account is not available for the portion of the distribution not includible in income, the portion of the distribution that would be includible in income qualifies for a 60-day rollover.²⁰

A rollover into a Roth IRA could be accomplished either through a direct trustee-to-trustee transfer or, if the distribution is made directly to the individual, the individual could roll over the entire distribution (or any portion thereof) into a Roth IRA within the 60-day period described in Sec. 402(c)(3).²¹ The rollover into a Roth IRA can be accomplished with an existing Roth IRA or a newly established Roth IRA, even if the individual is not otherwise eligible to make regular or conversion contributions because of the modified AGI limits in Sec. 408(A)(c)(3).²²

Rolling over the Roth 401(k) into a Roth IRA avoids RMDs, thereby continuing tax-free growth during the individual’s lifetime. This tax-free growth cannot be overemphasized.

Rollover Benefits

Exhibit 1 illustrates the benefit of a rollover from a Roth 401(k) into a Roth IRA.

Example 1: Assume (1) a plan accumulation of $1 million at age 69, (2) after-tax RMDs are reinvested in a taxable account, (3) a 25% tax bracket, and (4) all assets earn an 8% before-tax return (6% after-tax return) or a 12% before-tax return.

The top half of Exhibit 1 shows results for an 8% return. With a rollover, by the time the individual reaches the average life expectancy of 78 years, the benefit of the rollover is almost $200,000. At age 90, the benefit of the rollover is almost $1,300,000.

The bottom half of Exhibit 1 shows results using a 12% before-tax return. With a rollover, by the time the individual reaches an average life expect-ancy of 78 years, the benefit of the rollover is over $250,000. At age 90, the benefit of the rollover is over $3 million. Also, at age 90, the benefit of the rollover at 12% versus the rollover at 8% is over $5,500,000. As can be seen from the above example, tax-free growth cannot be overemphasized, and the rate of return is a huge factor in that tax-free growth.

Upon the individual’s death, if the spouse is the beneficiary of the Roth IRA, the spouse can also defer minimum distributions during the spouse’s lifetime. If the spouse is not the beneficiary or upon the spouse’s death (if the spouse is the beneficiary), subsequent beneficiaries would be required to take minimum distributions based on life expectancy using Table I (Single Life Expectancy) found in Appendix C of IRS Publication 590, Individual Retirement Arrangements (IRAs). All distributions made to beneficiaries would still be tax free, making the Roth 401(k) rollover to a Roth IRA extremely attractive.

Assessing the Benefits of a Roth 401(k) vs. a Traditional 401(k)

Many employers do not currently offer their employees the option to invest in a Roth 401(k). However, if an individual’s employer does offer this option, is the Roth 401(k) or the traditional 401(k)/403(b) the better option?

If an individual is currently in a lower tax bracket than that expected at retirement, the individual should consider a Roth 401(k). This could be the case if an individual gets divorced near retirement and does not remarry, or if an individual’s spouse dies near the individual’s retirement and the individual does not remarry. For example, in 2008, for a married individual filing jointly, the 25% bracket starts at $65,100; however, for a single individual, the 25% bracket starts at just $32,550. RMDs could also result in a higher tax bracket.

Example 2: Until retiring at age 61, D contributes $15,500 each year for 20 years in (scenario 1) a pre-tax 401(k)/403(b) or (scenario 2) an after-tax Roth 401(k). After retiring, D rolls over the Roth 401(k) into a Roth IRA; until age 70, D is in a 15% tax bracket. Assume a 25% tax bracket upon taking any RMDs from the 401(k)/403(b). All after-tax distributions are reinvested in a taxable account, which includes after-tax accumulated tax savings during the contribution years (resulting from not being taxed currently on the contributions) and after-tax accumulated RMDs. Also assume an 8% before-tax return on all investments. Exhibit 2 summarizes the asset values.

At age 80, D would have accumulated over $50,000 more under the Roth 401(k) scenario, whereas at age 90, D would have accumulated over $1,100,000 more under the Roth 401(k) scenario. Therefore, the longer D lives, the more attractive the Roth 401(k) scenario becomes. Furthermore, the entire balance in the Roth 401(k) scenario can, upon death, be transferred to beneficiaries tax free, whereas the amount remaining in the 401(k)/403(b) will eventually be taxed to beneficiaries under the RMD rules.

The retirement plan owner cannot predict whether beneficiaries will take minimum distributions, accelerated distributions, or a lump-sum distribution. For planning purposes, it would be prudent for the plan owner to assume the worst-case scenario when comparing a traditional 401(k)/403(b) with a Roth 401(k).

From Example 2, assume the beneficiaries elect a lump-sum distribution that equates to the least amount of tax deferral for the beneficiaries. If D died at an average life expectancy of age 78, the additional tax on the lump-sum distribution at 35% would be almost $650,000 ($1,830,498 × .35). At age 78, D would have accumulated only about $25,000 more in the 401(k)/403(b) alternative. Clearly the Roth 401(k) alternative is more attractive because beneficiaries will net about $625,000 more than under the traditional 401(k)/403(b).

If death occurs at age 90, the Roth 401(k) alternative is extremely attractive. The additional 35% tax on the lump-sum distribution would be almost $750,000 ($2,127,581 × .35) and the individual would have accumulated over $1,100,000 more in the Roth 401(k) alternative, leaving beneficiaries with about $1,850,000 more than under the traditional 401(k)/403(b) alternative. Again, as the individual ages, the more attractive the Roth 401(k) alternative becomes.

If retirement assets experience significant gains, the Roth 401(k) becomes even more attractive.

Example 3: Assume all the facts in Example 2, except that (1) the before-tax return on assets is 12%, and (2) the tax bracket is 33% upon taking any required minimum distributions under the traditional 401(k)/403(b) alternative. Exhibit 3 summarizes the asset values.

Increasing the rate of return from 8% to 12% significantly increases the value of the Roth 401(k) alternative as compared with the traditional 401(k)/403(b) alternative. At an average life expectancy of 78, the individual has already accumulated over $300,000 more under the Roth 401(k) alternative. By the time the individual reaches age 90, the individual would have accumulated almost $9 million more under the Roth 401(k) alternative compared with the traditional 401(k)/403(b) alternative and over $23 million more under the Roth 401(k) at 12% rather than at the 8% in Example 2.

The above examples assume that all RMDs are reinvested; however, many individuals will not have the ability to reinvest all RMDs. Even if RMDs are consumed, the Roth 401(k) is still an attractive alternative to the traditional 401(k)/403(b).

Example 4: Assume the same facts as in Example 2, except (1) RMDs are not reinvested but consumed, and (2) the amounts of RMDs (after tax) are also taken as tax-free distributions (and consumed) under the Roth 401(k) alternative. Exhibit 4 summarizes asset values.

At age 80, D would have accumulated approximately the same amounts under the Roth 401(k) and traditional 401(k)/403(b) alternatives, but, at age 90, D would have accumulated almost $600,000 more under the Roth 401(k) alternative. Assuming the beneficiaries take a lump-sum distribution at death and D died at an average life expectancy of age 78, the additional tax on the lump-sum distribution at 35% would be almost $650,000 ($1,830,498 × .35). At age 78, D would have accumulated about $70,000 more in the 401(k)/403(b) alternative. The Roth 401(k) alternative is more attractive because beneficiaries will net about $580,000 more than under the traditional 401(k)/403(b) alternative.

If D died at age 90, the Roth (401)(k) alternative is extremely attractive. The additional tax at 35% on the lump-sum distribution would be almost $750,000 ($2,127,581 × .35), and D would have accumulated almost $600,000 more in the Roth 401(k) alternative, leaving beneficiaries with about $1,350,000 more than under the traditional 401(k)/403(b) alternative. Again, as D ages, the Roth 401(k) alternative becomes more attractive.

What if an individual is in a higher tax bracket during the working years than at retirement? Is the Roth 401(k) still attractive?

Example 5: Assume the same facts as in Example 2, except the tax rates are (1) 35% until retirement, (2) 15% upon retirement, and (3) 25% once RMDs begin. Exhibit 5 summarizes the results.

It would take until age 84–85 (rather than age 78–79 as in Example 2) for D to accumulate approximately the same under the Roth 401(k) and traditional 401(k)/403(b) alternatives. The taxable asset account under the traditional 401(k)/403(b) alternative grows much quicker in accumulating tax savings at 35% versus 15% in Example 2. However, by age 90, D would have accumulated over $600,000 more under the Roth 401(k) alternative. Therefore, it appears that the Roth 401(k) is still an attractive alternative even if the individual is in a higher bracket during the working years than at retirement.

In general, upon retirement, assets should be consumed in the following order:

1. Nonretirement assets/taxable accounts;

2. Retirement accounts other than Roth accounts; and

3. Roth accounts (Roth 401(k)/Roth IRA).

Furthermore, except in unusual circumstances, an individual should always defer taking any distributions from retirement accounts until the RMD rules apply. However, for a number of reasons, such as the purchase of a retirement home, a second home, or a new business, an individual may decide to withdraw the entire balance in a lump sum or take payments over a relatively short period of time. How does the Roth 401(k) measure up under these circumstances?

Example 6: D contributes $15,500 for 20 years in alternatively a 401(k)/403(b) or a Roth 401(k). During the contribution years, D is in a 15% tax bracket. D decides to withdraw the balance alternatively in a lump sum, over 5 years or over 10 years. Assume the lump-sum distribution does not qualify for 10-year averaging. Since the distributions from the 401(k)/403(b) will be fully taxable, assume that all traditional 401(k)/403(b) distributions are taxed at 33%. Also, assume an 8% before-tax return on all investments. Exhibit 6 summarizes the after-tax distributions.

In all cases, the Roth 401(k) results in greater after-tax distributions.

As illustrated in Example 3, if retirement assets experience significant gains, the Roth 401(k) becomes even more attractive.

Example 7: Assume the facts of Example 6, except (1) a 35% rather than a 33% tax bracket on all traditional plan distributions, and (2) a 12% rather than an 8% before-tax return on all assets. The results are shown in Exhibit 7.

As in Example 6, in all cases, the Roth alternative results in greater after-tax distributions. In addition, the benefit under the Roth alternative of a 12% rather than an 8% return is significant. For instance, with 10-year distributions, the distribution is over $90,000 more per year at 12% versus 8%.

All retirement calculations involve tax bracket assumptions, and one can only guess what the tax brackets will be in the future. The Roth 401(k) should almost always be the first choice because the funds can be rolled over into a Roth IRA upon retirement and will have tax-free growth for at least the individual’s lifetime. If a younger individual has 40 years or so to contribute to a retirement plan, the Roth 401(k) plan is also a great choice.

Other Benefits

Another benefit of the Roth 401(k) is to further an individual’s retirement investment diversification. If an individual currently participates in a traditional 401(k)/403(b) plan, the individual should consider participating in a Roth 401(k). Upon retirement, he or she could take RMDs from the traditional plan and roll over the Roth 401(k) into a Roth IRA. This allows the individual to diversify the funds into investments not offered by the 401(k)/403(b) plan and to continue the tax deferral on the investments. It would be advisable to take distributions from the Roth IRA only if ab-solutely necessary because, upon death, beneficiaries would receive the Roth IRA tax free under Sec. 102 and RMDs taken by beneficiaries would be tax free.

Another potential use of the Roth 401(k) that represents a significant advantage over the traditional plans is when an individual must withdraw funds to pay for a child’s or grandchild’s college education. Yearly tuition at many colleges currently exceeds $30,000. In 10 years, assuming 5% increases in tuition, annual costs at many colleges will be over $50,000. Parents and grandparents need to consider tax-advantaged investments in planning for their children’s or grandchildren’s education. Many taxpayers do not have the ability to maximize retirement contributions and properly fund their children’s or grandchildren’s education through Sec. 529 plans, Coverdell education savings accounts, or other investments.

Assuming the parent or grandparent will be at least 59½ before their child or grandchild goes to college, that parent or grandparent could take qualified distributions (tax free) from the designated Roth account to pay for the child’s education. Although this is similar to what would happen under a Sec. 529 plan, the Roth 401(k) is much more flexible. Sec. 529 plan distributions are tax free only if used for college, whereas Roth 401(k) distributions are tax free regardless of how the distribution is used. A Roth 401(k) distribution can be used for K–12, college, or for that matter any other purpose. In addition, contributions to a Roth 401(k) may be eligible for employer matching under a 401(k)/403(b) plan.

Conclusion

A fundamental tax planning principle is to avoid paying income taxes currently and defer the payment of taxes to future years if at all possible. The Roth 401(k) goes against this basic principle because the individual pays income taxes on the designated Roth contribution now rather than deferring the tax payment on elective contributions made to a traditional 401(k)/403(b). However, this additional tax cost is more than outweighed by the benefits of the Roth 401(k), including (1) diversifying retirement investments, (2) tax-free growth during an individual’s lifetime and possibly during a beneficiary spouse’s lifetime, (3) tax-free income on qualified distributions, and (4) deferral of tax-free RMDs by rolling over the Roth 401(k) into a Roth IRA. Because of these significant benefits, individuals should seriously consider the Roth 401(k) in planning for retirement.

EditorNotes

For more information about this article, contact Prof. Beausejour atdbeausej@bryant.edu.

Notes

¹ The qualified Roth contribution program rules apply to both Sec. 401(k) cash or deferred arrangements and Sec. 403(b) annuities. This article employs the term “Roth 401(k)” to refer to both 401(k) and 403(b) arrangements.

² Sec. 402A(b)(1).

³ Sec. 402(g); Notice 2007-87, 2007-45 IRB 966.

⁴ Sec. 408A(c)(2); Sec. 219(b)(5)(B).

⁵ Sec. 402A(a)(1).

⁶ Sec. 402A(b)(2).

⁷ Sec. 408A(c)(3); Notice 2007-87, 2007-45 IRB 966.

⁸ Sec. 402A(d)(1).

⁹ Sec. 402A(d)(2), cross-referencing Sec. 408A(d)(2)(A).

¹⁰ Regs. Sec. 1.402A-1, Q&A-10.

¹¹ Sec. 402A(d)(2), cross-referencing Sec. 408A(d)(2)(A).

¹² Sec. 402A(d)(2)(B).

¹³ Regs. Sec. 1.402A-2, Q&A-1.

¹⁴ Regs. Sec. 1.402A-1, Q&A-10.

¹⁵ Regs. Sec. 1.402A-1, Q&A-3.

¹⁶ Id.

¹⁷ Sec. 402A(c)(3)(A).

¹⁸ Regs. Sec. 1.402A-1, Q&A-5(a).

¹⁹ Id.

²⁰ Regs. Sec. 1.402A-1, Q&A-5(c).

²¹ Regs. Sec. 1.402A-1, Q&A-5(a).

²² Regs. Sec. 1.408A-10, Q&A-2.