1 BLUE PAPER Roth 401(k): Creating a Tax-Advantaged Strategy for Retirement Roth 401(k) Helps Investors Take Diversification * to the Next Level. IN BRIEF January 2016 Just as a well-diversified portfolio can help protect an investor from market volatility, a well-diversified savings strategy can help protect retirement savings and earnings from tax liability in retirement. By offering a flexible option for potentially tax-free retirement income, the Roth 401(k) adds an important level of tax diversification to an investor s financial strategy for retirement. *Diversification does not assure a profit or protect against loss in a declining market.
2 BLUE PAPER Roth 401(k): Creating a Tax-Advantaged Strategy for Retirement January 2016 Key Points 1. R oth contributions help diversify a retirement savings strategy, helping protect investors from tax risk, essentially locking in today s historically low federal tax rates, and may result in less taxes paid overall than pre-tax contributions. 2. The Roth 401(k) offers potential advantages for many retirement savers with a wide range of needs, but particularly those just starting out, long-term savers, and high-income earners. 3. Unlike the Roth IRA, the Roth 401(k) imposes no income restrictions for annual contribution eligibility. For annual contributions this may be the best if not the only opportunity for high-income earners to accumulate assets potentially for tax-free income later on. 4. Roth 401(k) assets can be rolled into a Roth IRA. Doing so will give a Roth 401(k) investor important flexibility when it comes to taking withdrawals because unlike the Roth 401(k), a Roth IRA is not subject to Required Minimum Distributions (RMDs) at age 70½ for the original owner. It also allows for greater growth potential and the ability to establish a tax-free legacy for multiple generations. 5. A key decision investors and their tax advisors need to make before choosing a Roth 401(k) is whether they are willing to pay taxes now in exchange for potentially tax-free income when they retire. Pre-Tax Versus After-Tax Saving: The Great Balancing Act Saving after-tax dollars in a Roth 401(k) can give investors the opportunity and flexibility to hedge their bets against rising tax rates. Saving on a pre-tax basis allows money to grow tax deferred. With Roth, you trade the benefits of immediate tax savings (when contribution(s) are made), for control over tax liability when assets are withdrawn, as well as the added benefit of receiving potentially tax-free earnings. What s the right answer? For many people, it may be a combination of the two. Accumulating both pre-and after-tax savings can allow an investor to hedge bets and gain more maneuvering room for managing the overall tax bill in retirement. 2
3 Applying the key investing concept of diversification to a retirement savings strategy can help investors maximize potentially tax-free savings and minimize tax liability in retirement. Additional Rollover Information: If you are retiring or moving on to another job, your retirement plan asset distribution options to consider generally include: Choice 1: Take your retirement plan assets as a distribution. Choice 2: Leave your retirement plan assets in your former employer s plan. Choice 3: Transfer your retirement plan assets to your new employer s plan. Choice 4: Roll your retirement plan assets over into another IRA (Traditional or Roth IRA) or to a qualified plan - such as the Pioneer Uni-K Plan. It is important to note that this is not intended to be an all-encompassing discussion of distribution options available to you. In addition to these choices, you may wish to discuss the following factors with your financial advisor as you weigh your options: Ò Investment Options Ò Fees and Expenses Ò Services Ò Penalty-Free Withdrawals Ò Protection from Creditors Ò Required Minimum Distributions The availability of each may vary from plan-to-plan. Tax Diversification: Taking a Key Investing Strategy to the Next Level Can Help to Minimize Tax Liability in Retirement. Diversification. * This time tested concept plays a key role towards balancing risk and reward in an investor s portfolio. But as the nature of retirement income in America shifts away from guaranteed pensions, placing more emphasis and responsibility on the individual to save through defined contribution plans, it may be time to take diversification to the next level tax diversification. One of the best ways to do that may be through an after-tax savings vehicle like the Roth 401(k). Just as a well-diversified portfolio can help protect an investor from market volatility, a well-diversified savings strategy can help protect savings and earnings from tax liability. By offering a flexible option for potentially tax-free retirement income, the Roth 401(k) adds an important level of diversification to an investor s strategy for saving, retirement income and legacy planning. That's because it allows an investor to diversify how and when taxes are paid on the income earned from a 401(k). A volatile economy, escalating health care costs and an uncertain tax situation mean retirement will look much different for this and future generations, calling for even greater levels of replacement income in retirement. Now, more than ever before, it is critical that investors understand not only the investments they are putting their money into but the variety of savings options, both before and after-tax, available to them and how they can strategically utilize them to meet financial and retirement goals. Investors who are still actively saving for retirement should work with a financial advisor to evaluate how Social Security, pension and 401(k) savings, including Roth after-tax will work together to fund retirement. Pre-retirees and those currently in retirement should also understand the key role after-tax savings vehicles like Roth 401(k) can play in legacy-leaving retirement income and estate planning strategies. *Diversification does not assure a profit or protect against loss in a declining market. This paper will discuss the importance of applying lessons learned from investment diversification to saving in both before- and after-tax accounts to create a smart retirement strategy that can stand the test of time. It examines how Roth 401(k) can play an essential role in helping investors achieve savings diversification, and analyzes the opportunities available through converting some pre-tax dollars to Roth after-tax dollars. Volatility: A Fact of Fiscal Life The stock market has taken Americans and their retirement savings on a wild ride over the past several years. When it comes to saving, people are learning to expect the unexpected and today, the name of the investing game is uncertainty. The same is true for taxes. This is not your father s retirement and your effective tax bracket could possibly even go up, rather than down in retirement especially for high net worth households. As the chart on the next page illustrates, tax rates are already close to historically low rates. There have been only two periods in the last 50 years that income taxes were lower than what they are today. And, since 1980, the top marginal tax rate has fallen from 70% to a current 39.6%. How much lower can these rates really go in the future? 3
4 Top Marginal Tax Rates are Close to Historically Low Levels. How Much Lower Can They Go? Source: Internal Revenue Service as of December, For many investors, an answer may be to diversify not only their investment holdings but their tax liability. One way to do that is to include Roth 401(k) as part of a diversified savings strategy. Roth 401(k): An Overview The Roth 401(k), which first became available in 2006, is similar to the Roth IRA in that taxes are paid up-front, when contributions are made. Any subsequent growth on the Roth 401(k) account may be received tax-free when withdrawn, provided certain requirements are met. However, Roth 401(k) rules allow for dramatically higher annual contribution amounts than the Roth IRA up to $18,000 ($24,000 for investors age 50 or older) in the 2016 tax year versus just $5,500 ($6,500 for investors age 50 or older) for the Roth IRA. Under the regulations, Roth contributions can be made to a new or existing 401(k) plan either as a substitute for or complement to pre-tax contributions (provided that the 401(k) Plan allows for Roth contributions). Since the passage of EGTRRA, Congress has continued making Roth more accessible with the advent of In-Plan Roth conversions which will be discussed later in this paper Contributions to a Roth 401(k) are made on an after-tax basis and earnings grow tax free, giving an investor options for a withdrawal strategy at retirement. Depending on the investor s age and tax situation, he or she may choose to delay withdrawing from (and paying taxes on) a pre-tax account in early retirement by tapping into Roth 401(k) after-tax assets first. While Roth 401(k) contributions may hold appeal for millions of investors, perhaps no group may be more interested than high-income earners. That s because, unlike the Roth IRA, there are no income limits on investors who want to make annual Roth 401(k) contributions. In addition, the Roth 401(k) can be a highly effective estate planning tool, potentially helping to stretch assets and minimize taxes for decades. Roth 401(k) Benefits Potentially tax- and penalty-free income in retirement: Roth 401(k) allows investors to direct all (or a portion of) their deferrals to an account established to provide tax-free income in retirement. The contributions to a Roth 401(k) are made on an after-tax basis and earnings grow potentially tax-free. In other words, you are paying taxes now, not later, when distributions are received. Why is this so important? It gives an investor options for a withdrawal strategy in retirement. Depending on the investor s tax situation, he or she may choose to delay withdrawing from (and paying taxes on) a pre-tax account in early retirement by tapping into Roth 401(k) after-tax assets first. Additionally, over time, Roth earnings may grow to exceed the taxes paid when the contributions were made. Note that Roth contributions are irrevocable; once they are allocated to a Roth 401(k) account, they cannot be shifted to a pre-tax account. Also, keep in mind that tax free qualified distributions from the Roth account will be allowed only in the cases of death, disability or attainment of age 59½ when a five-year waiting period has been 4
5 satisfied (i.e., it has been at least five years since the initial Roth 401(k) contribution under the plan was made). Roth 401(k) s tax-advantaged benefit works with pre-tax savings, pension income and Social Security to help deliver a balanced financial plan for retirement. An added level of savings diversification: Roth 401(k) s tax-advantaged benefit works with pre-tax savings, pension income and Social Security to help deliver a balanced financial plan for retirement. At any age, but especially in retirement, Roth 401(k) assets give an investor an important and flexible advantage: to have control over what portion of retirement income is subject to taxes by dialing-up (or down) the amount of qualified Roth distributions. This may become even more important when Social Security benefits are being received, as qualified Roth distributions are not counted in income when determining if some or all of Social Security benefits are taxable. Estate planning flexibility: A powerful legacy-leaving strategy employs the use of Roth assets, which, together with the presence of a younger beneficiary, such as a child or grandchild, can stretch potentially tax-free withdrawals over decades. Required Minimum Distribution (RMD) Flexibility: A Roth 401(k) account can be rolled into a Roth IRA, helping the original owner to avoid the need to take required minimum distributions from Roth 401(k) assets. Determining whether or not a Roth 401(k) is right for any particular investor is essentially a tax planning issue, says David Wray, president of the Profit Sharing/401(k) Council of America (PSCA). With the Roth 401(k) the question you really have to ask yourself is 'Does it makes more sense to pay taxes now or later?' * For investors who can afford to set aside the maximum contribution amounts, the Roth 401(k) may be a clear chance to build wealth while saving tax dollars in the long run. *Pioneer Funds Distributor, Inc. is not affiliated with the Profit Sharing/401(k) Council of America. Roth Considerations Tax rate today versus tax rate in retirement: In assessing whether a Roth 401(k) may be right for an investor's needs, one of the critical determinants is whether he or she will be in a higher tax bracket in retirement. Predicting future tax rates in retirement is difficult to determine because there are so many variables: Another point to consider over and above what tax rate you will be in retirement is the issue of when the taxes are actually paid. Paying taxes now when you may have greater disposable income may be preferable, versus later in retirement, where you may have competing priorities, such as out-of-pocket healthcare costs while having fixed income. How much money an investor will be drawing in retirement from taxable sources like pensions, pre-tax accumulations in 401(k) and traditional IRA accounts Amount of interest and capital gains an investor will generate in taxable investment accounts after retirement How much might be earned from work in retirement Other significant sources of income Legislative decisions on tax rates Estate planning strategies Given this uncertainty, Roth contributions could benefit a range of people, for example: Just starting out: Someone new to the workforce will most likely be in a low tax bracket today so the tax benefits of pre-tax saving may not be as significant. This could be the time to build up after-tax savings, diversifying into pre-tax savings as a higher tax bracket is achieved. Long term saver: A person who has saved through the years, particularly on a tax deferred basis, may find him or herself in the same or higher tax bracket at retirement due to withdrawals from pre-tax savings. Roth assets will give this investor some needed flexibility to put off withdrawing from pre-tax accounts until well into retirement and potentially in a lower tax bracket. High income earner: High income earners who are saving the maximum allowable pre-tax amount can defer more in a retirement account when using Roth savings because the same dollar limit, $18,000 ($24,000 if age 50 or older) in 2015, is applied with either pre-tax or Roth contributions. 5
6 How Does the Roth 401(k) Stack Up Against Other Retirement Accounts? Whether it s a business owner evaluating retirement plan options, a high-income earner considering tax-advantaged retirement programs or a pre-retiree concerned with estate planning issues, the Roth 401(k) offers numerous potential advantages. The following table offers a comparison between Roth 401(k) and some of the more well-known retirement savings options available today Retirement Account Comparison Pre- or after-tax savings Who may establish/save Annual contribution limit 2 Roth 401(k) Roth IRA Traditional IRA SEP SIMPLE IRA After-tax savings for employee; any employer contributions remain pre-tax Any business may establish; any employee may contribute Employees can defer up to $18,000 ($24,000 if age 50 or older). Total salary deferral and employer contributions cannot exceed 100% of pay up to $53,000 ($59,000 if age 50 or older). 3 Contributions of higher-paid employees may be limited based on discrimination test. Loan availability Withdrawals Generally allowed after age 59½, plan termination, termination of employment, death or disability. Subject to income tax; a 10% penalty may apply before age 59½. Earnings attributable to Roth contributions entirely tax free if certain conditions are met. 4 Subject to Required Minimum Distribution (RMD) 1 The $5,500 ($6,500 if age 50 or older) maximum Roth IRA contribution is reduced for those with income between $117,000-$132,000 (single) and $184,000-$194,000 (joint). 2 No more than $265,000 of compensation may be taken into account. 3 The amount available for loans depends on (certain plan provisions and) the current value of the account, which may be worth more or less than the amount invested. Failure to repay the loan according to the terms may result in its being treated as a deemed distribution and, if under age 59½, subject to a 10% federal tax penalty. 4 Conditions include attaining age 59½, becoming disabled or death as well as meeting a five-year requirement. 5 Conditions include attaining age 59½, becoming disabled, using up to $10,000 to buy a first home, or upon death as well as meeting a five-year requirement. 6 Original account owner is exempt; beneficiaries must take RMD. After-tax savings Anyone may establish and contribute, provided annual gross income does not exceed $132,000 (single tax return); $194,000 (joint tax return) $5,500 ($6,500 1 age 50 or older) Pre-tax savings (contributions may be non-deductible, depending upon income, filing status, and participation in an employer-sponsored retirement plan) Anyone under age 70½ may establish and contribute $5,500 ($6,500 for age 50 or older) Pre-tax savings Sole proprietors, partnerships, corporations, nonprofit and government entities establish and contribute 25% of pay (20% for self-employed) up to $53, Yes 3 No No No No Yes, but can be avoided by rolling balance into a Roth IRA Allowed anytime. Entirely tax-free if certain conditions are met. 5 Allowed anytime, generally subject to income tax. A 10% penalty may apply before age 59½. Allowed anytime, generally subject to income tax. A 10% penalty may apply before age 59½. No 6 Yes Yes Yes Pre-tax savings Employers with 100 or fewer employees, including sole proprietors, partnerships, corporations, nonprofit and government entities. Must generally be employer s only plan. Employer and employees contribute Employees: $12,500 ($15,500 for age 50 or older); Employer makes additional required contributions Allowed anytime, subject to income tax. A 10% penalty (increases to 25% during first two years of participation) may apply before age 59½. 6
7 "Is a conversion for me?" Like all of the other options that you are considering, converting to a Roth does not come without its own unique risks, most notably - what happens if tax rates are lower in the future or more accurately, what happens if the effective tax rate you pay at the time of conversion is actually higher than when you receive distributions at some point in the future, but keep in mind, converting to a Roth is not simply a discussion about future tax rates - it is more than that, it also encompasses how future earnings, if any, will be taxed. When you receive distributions from a Roth account, if it is considered a Qualified Distribution, then the entire distribution will be tax and penalty free. Contrast this to a distribution of taxable amounts from a tax-deferred account - where all pre-tax amounts received will have to be included in income for the tax year received. Converting Traditional Retirement Savings to Roth A Roth conversion is a mechanism that allows IRA owners and plan participants (provided that the plan allows) to move or convert all or a portion of their traditional retirement savings to Roth. Virtually all individuals with an eligible retirement plan assets who are willing to pay conversion taxes are eligible to convert assets to Roth. Traditional IRA assets, including contributions made to your Traditional IRAs under simplified employee pension (SEP) plans, may be converted to a Roth IRA. SIMPLE IRA assets may also be converted to a Roth IRA as long as it has been at least two years since you first received a SIMPLE IRA contribution under the employer s SIMPLE IRA plan. In addition, eligible distributions from qualifying employer retirement plans may be rollover (converted) to your Roth IRA. Qualifying employer retirement plans include qualified plans (e.g., 401(k) plans or profit sharing plans), governmental 457(b) plans, 403(b) arrangements, and 403(a) arrangements. Under current law there are two transaction types that provide for the conversion of traditional retirement assets to Roth: Roth IRA conversions and in-plan Roth conversions. Roth IRA Conversions Beginning January 1, 2010, the $100,000 modified adjusted gross income (MAGI) limitation on conversions to Roth IRAs, as well as the restriction that married couples filing separately are not eligible to convert to a Roth IRA were eliminated. As a result, almost anyone with an IRA (including Traditional, Rollover, SEP and SIMPLE IRAs) may be eligible to convert to a Roth IRA. Eligible investors may also roll over (convert) eligible rollover distributions from employer retirement plans to Roth IRAs. The taxable conversion amount is taxed as ordinary income for the year of conversion. Note: You must have participated in the SIMPLE IRA plan for two years before the SIMPLE IRA account can be converted to a Roth IRA. In-Plan Roth Conversions Roth conversions within employer-sponsored plans (401(k) plans, 403(b) plans, and governmental 457(b) plans) are called "in-plan Roth rollovers", which if the plan allows, may be available to plan participants. This means that participants don't have to roll out of the plan to a Roth IRA if they want to convert. Provided the plan allows, they can simply convert inside of the plan to gain greater Roth accumulations. Participants should check with the plan administrator to determine if this option is available for the plan. While the in-plan Roth conversion option resembles the Roth IRA conversion option in many ways, there are a number of differences between the two alternatives. Comparing Roth In-Plan Conversions to Roth IRA Conversions* While the in-plan Roth conversion option resembles the Roth IRA conversion option in may ways, there are a number of differences between the two alternatives, as illustrated in the chart below. Converting In-Plan Converting to a Roth IRA Recharacterizations allowed? No Yes Contributions (and converted amounts) come out first on withdrawals? No Yes Continued access to loans? Yes No RMD requirements for original account owner? Yes** No * This is not intended to be a comparison of all the conversion features. Consult a qualified tax advisor. ** Plan participants who roll Roth 401(k) assets to a Roth IRA will avoid RMDs. 7
8 Conclusion Roth is a retirement income strategy that most people should consider. Today s investors face a number of competing financial priorities, including tax management, saving for retirement, as well as transition and estate planning. While no one can truly predict what tax brackets will look like in the future, it is safe to say that now, more than ever before, investors are becoming increasingly responsible for their own retirement destiny. What can investors do today to help preserve financial security for the future? Take action. Meet with a financial advisor to discuss how balancing pre-tax assets with a Roth 401(k) can help to preserve and maximize investment dollars in retirement. A fully diversified savings strategy one that provides both savings and asset diversification is a critical step towards helping investors reach short- and long-term financial goals. You should always consider your risk tolerance and investment objectives when considering investment options. Mutual funds can involve significant risks including investments in equities, which may offer a high rate of return, but can be more volatile than fixed income investments. Fixed income investments involve risks associated with interest rate fluctuations and an issuer s ability to fulfill their debt obligations. Your investment return and principal value will fluctuate and a fund s shares, when redeemed, may be worth more or less than their original cost. The fund s prospectus includes complete details on the risks associated with an investment in the fund. The amount available for loans depends on certain plan provisions and the current value of your account, which may be worth more or less than the amount you invested. Withdrawals of earnings or other taxable amounts may be subject to income tax and, if made prior to age 59½, may be subject to an additional 10% federal tax penalty. This material is not intended to replace the advice of a qualified attorney, tax advisor, investment professional or insurance agent. Before making any financial commitment regarding the issues discussed here, consult with the appropriate professional advisor. The investments you choose should correspond to your financial needs, goals and risk tolerance. For assistance in determining your financial situation, please consult an investment professional. Please consider a fund s investment objectives, risks, charges and expenses carefully before investing. The prospectus or summary prospectus contains this and other information about a fund and should be read carefully before you invest or send money. To obtain a prospectus and for other information on any Pioneer fund, contact your advisor, call or visit our web site at us.pioneerinvestments.com. To receive automatic notification of updates to this and other Pioneer thought leadership pieces, sign up at us.pioneerinvestments.com/enotify, or look for this icon on our website. Securities offered through Pioneer Funds Distributor, Inc. 60 State Street, Boston, Massachusetts Underwriter of Pioneer mutual funds, Member SIPC 2015 Pioneer Investments us.pioneerinvestments.com