Reprinted with permission from the Society of FSP. Reprodction prohibited withot pblisher's written permission. Roth 401(k) and Roth 403(b) Acconts: Why a Roth Election Shold Be Part of Yor Plan Now by David J. Campbell, CFA William R. Urban, CFP, CFA Abstract: Starting in 2006, the ability to make elective deferrals in a 401(k) or 403(b) plan and elect to designate them as after ta Roth deferrals is one of the most powerfl retirement savings plan enhancements created by Congress since the advent of the 401(k) plan itself. Unfortnately, very few 401(k) plan sponsors have moved aggressively to adopt the Roth featre for their eisting plans, even thogh significant nmbers of employees wold be sbstantially better off making the Roth election. This analysis qantifies the benefit of making the Roth 401(k) election in a srprisingly wide range of employee scenarios and reveals that yonger, lower paid workers may be the biggest beneficiaries of the Roth 401(k), not jst highincome workers. This analysis also eamines additional benefits of the Roth 401(k), sch as the ability to preferentially allocate assets with different epected retrns between traditional 401(k) and Roth 401(k) acconts, and to roll over a Roth 401(k) to a Roth IRA and delay mandatory distribtions beyond age 70 1 2. This isse of the Jornal went to press in October 2006. Copyright 2006, Society of Financial Service Professionals. T he ability to make contribtions starting in 2006 to a 401(k) or 403(b) plan and elect to designate them as after-ta Roth deferrals is one of the most powerfl retirement savings plan enhancements created by Congress since the introdction of the 401(k) plan itself. Unfortnately, very few 401(k) or 403(b) plan sponsors have moved aggressively to adopt the Roth featre for their eisting plans, even thogh significant nmbers of employees wold be sbstantially better off making the Roth election. This analysis qantifies the benefit of making the Roth election across a wide range of employee scenarios and reveals that yonger, lower paid workers may be the biggest beneficiaries of the Roth option, not jst highincome workers. There are other compelling benefits of the Roth 401(k) or 403(b), sch as the ability to preferentially allocate assets with different epected retrns between traditional and Roth 401(k)/403(b) acconts, and to roll over a Roth 401(k)/403(b) to a Roth IRA and delay mandatory distribtions beyond age 70 1 2. Financial advisers and 401(k) or 403(b) plan sponsors shold be proactive in offering the advantages of the Roth option to their clients and employees. Athor s note: President Bsh signed into law the Pension Protection Act of 2006 on Agst 17th, after the sbmission of this article. As part of that legislation, several temporary provisions of 2001 EGTRRA that were set to epire after December 31, 2010, were made permanent, inclding Roth 401(k) and 403(b) elective deferrals. Now that the ftre of Roth 401(k) and Roth 403(b) acconts are assred, we epect many more employers to amend their plans to add this featre by the end of 2006. 79
Roth 401(k) and Roth 403(b) Acconts: It shold be noted that final reglations for Roth 401(k) elective deferrals were issed at the beginning of 2006 effective for plan years beginning on or after Janary 1, 2006. Final reglations for 403(b) plans had not been issed at the time of this article s sbmission, bt were epected in mid-2006 and were to be effective as of Janary 1, 2007. However, the inclsion of proposed Roth 403(b) rles as part of the proposed Roth 401(k) reglations demonstrates the IRS s stated goal to align these two types of plans, making them similar in appearance and operation. In addition, the Service has advised sponsors they may rely pon the proposed rles ntil the final reglations are issed. Ths, in this article, we will refer to 401(k) acconts only since the items discssed shold apply to both eqally. Plan sponsors shold review these rles with their pension advisers before adopting the new Roth option. Thanks to the Economic Growth and Ta Relief Reconciliation Act of 2001 (EGTRRA), for the first time 401(k) retirement plan participants may be able to make contribtions to a Roth 401(k) accont as an alternative to a traditional 401(k) accont. Similar to the Roth IRA in its basic operation, the Roth 401(k) will offer some significant advantages over its older cosin. Per EGTRRA, the Roth 401(k) featre may be offered in company retirement plans as of Janary 1, 2006, althogh companies are not reqired to do so. A few key featres of the Roth 401(k) worth highlighting are as follows: Elective deferrals to a Roth 401(k) accont are made on an after-ta basis (i.e., will be inclded in taable earned income). Starting in 2006, this means that p to $15,000 of elective deferrals pls $5,000 of catch-p contribtions (for those age 50 or over) can be contribted by a participant. Traditional 401(k) contribtions are made on a preta basis and are not taable as crrent income. Plan sponsors may (bt are not reqired to) allow participants to split their elective contribtions between the traditional and the Roth 401(k) acconts, choosing one or both, so long as the total of all elective deferrals does not eceed the above limits. While assets are in the Roth 401(k), they will enjoy tafree growth, the same as for traditional 401(k) assets. Upon retirement (sally age 59 1 2 or later), withdrawals from Roth 401(k) acconts are ta free. In contrast, traditional 401(k) distribtions are flly taable at ordinary income ta rates. Unlike the adjsted gross income limits established for qalifying contribtions to a Roth IRA ($110,000 for singles and $160,000 for married filing jointly), no income limitations apply for contribtions to Roth 401(k) acconts. Frthermore, the Roth 401(k) contribtion limits are mch higher than the $4,000 reglar and $1,000 catch-p amonts (2006) for Roth-IRAs. Table 1 contrasts the main featres of the Roth verss traditional 401(k) accont. It shold be noted that the law establishing the Roth 401(k) is set to lapse after 2010. However, as is the case for many other provisions nder EGTRRA set to epire between 2006 and 2010, considerable advantages can be reaped between now and then, and Congress is likely to revise this provision by etending it or making it permanent. Choosing between Traditional and Roth 401(k) Deferrals The biggest decision for participants is whether to make their elective contribtions to a traditional or Roth 401(k) accont. After carefl analysis, it appears that the Roth 401(k) may be the better choice for far more people than commonly nderstood. Let s take a look at some eamples. Consider two identical workers, A and B, each age 45 and having ecess earnings of $21,429 to tilize toward retirement savings (all figres are ronded). Sppose also that each worker pays taes on ordinary income at a 30% rate both before and after retirement, earns a flat 7.5% rate of retrn on all investments, and pays taes on all gains in taable acconts at a 20% rate. Assme also that pon retirement at age 65, each then withdraws from their savings evenly over a 25-year retirement period. Finally, let s assme that as each worker reaches age 50, they contribte an etra $5,000 as a catch-p contribtion to their traditional or Roth 401(k) accont. Worker A chooses to tilize a traditional 401(k) for his retirement savings, placing any ecess savings available in a separate taable accont. $15,000 is placed into the traditional 401(k) in year one and is not inclded in taable income. The etra $6,429 he can afford to save is inclded in taable income. After paying income taes of $1,929 (30%), he then has $4,500 to invest in a taable accont. Worker B chooses to tilize a Roth 401(k) for her 80
Roth 401(k) and Roth 403(b) Acconts: retirement savings. $15,000 is placed into this accont in year one and is inclded in her taable income. Taes on the fll $21,429 come to $6,429, which leaves no additional amont to add to savings. Which worker has more after-ta income in retirement? In this case, it s Worker B, who cold then withdraw $67,547 annally dring retirement, while Worker A wold net only $62,520, or $5,028 less annally and $125,688 less cmlatively over the 25-year retirement period. This amonts to an 8% increase in after-ta retirement income by sing the Roth 401(k) rather than the traditional 401(k) accont. What if a worker is nwilling or nable to contribte the fll amont for which he or she is eligible into a 401(k) accont? For eample, if a participant can only allocate a total of $10,000 annally for savings of all types, he or she cold choose between placing all $10,000 in a traditional 401(k) or $7,692 in a Roth 401(k) and paying taes of $2,308 (30%). If that is the choice, then the worker will have eactly the same after-ta income in retirement either way as long as his or her ta rate does not change. In effect, the 45-year-old worker wold have wasted the potential increase in after-ta income, even with no change in ta rate, becase he or she did not take fll advantage of the maimm contribtion amont to the Roth 401(k). In this respect, it cold be arged that the Roth 401(k) does benefit the higher income worker more, if it is more likely that the higher income worker can take fll advantage of the maimm Roth 401(k) contribtion limit and pay the taes on that contribtion from other earnings or savings. A better way to say it is that the Roth 401(k) benefits those who are willing to save more, regardless of their income. Misleading Rles of Thmb When trying to help workers decide between Roth and traditional 401(k) acconts, two rles of thmb are often cited. The first rle goes something like this: If yo epect to be in a higher ta bracket in retirement, a Roth 401(k) may be the better choice since yo won t pay taes on qalified distribtions of earnings. If yo epect to be in a lower ta bracket in retirement, then a traditional, preta contribtion may make more sense for yo. The second rle assmes that Roth 401(k) acconts mainly benefit higher-paid workers. Unfortnately, both of these rles of thmb can be very TABLE 1 Smmary of Key Featres (Based pon final reglations issed by the IRS and U.S. Treasry Dept. on Janary 3, 2006.) Roth 401(k) Traditional 401(k) Participant elective deferrals After-ta Preta 2006 maimm contribtion a $15,000 $15,000 2006 maimm catch-p contribtion (age 50 and over) a $5,000 $5,000 Company matching contribtions b Cannot be designated as Roth Made on a preta basis and contribtions. Made on a preta taed as ordinary income basis and taed as ordinary pon distribtion. income pon distribtion. Earnings growth Ta free Ta deferred Qalified distribtions c Ta free Taable as ordinary income Minimm distribtions reqired at age 70 1 2 d Yes d Yes a These limits are cmlative between the traditional and Roth options (i.e. split contribtions cannot eceed $15,000 in total for reglar contribtions, nor $5,000 in total for catch-p contribtions, in 2006). b All Roth 401(k) deferrals and earnings on Roth deferrals mst be tracked and acconted for separately from those made on a preta basis. c As with Roth IRAs, contribtions and earnings can be withdrawn from Roth 401(k) acconts ta free after age 59 1 2 (or pon disability or death), provided the accont has been held for at least five years. d Assets held in Roth 401(k) plan acconts will be sbject to the reqired minimm distribtion (RMD) rles established for other qalified plans and IRAs. Generally, distribtions mst begin when the plan participant reaches age 70 1 2. If the participant has separated from service (retired or is no longer employed by the company), it is possible to avoid RMD amonts at age 70 1 2 by rolling over Roth 401(k) assets into a Roth IRA accont. 81
Roth 401(k) and Roth 403(b) Acconts: misleading and cold reslt in the wrong decision. Let s take a look at the first generalization to see how accrate it might be as a gideline. What happens if yor income ta bracket is actally higher in retirement? Assming in the above case that both workers wold pay taes on ordinary income at a 35% rate in retirement, the benefit from the Roth accont is even greater $67,547 net annal income for worker B verss $59,142 for worker A, a difference of over 14%. This is clearly in line with the rle of thmb. However, a lower ta bracket in retirement does not atomatically mean one shold choose to se the traditional 401(k) over the Roth. In fact, for or workers above, the retirement TABLE 2 Smmary of Changes to the Workers A and B Eample % Advantage/ (Disadvantage) to Roth 401(k) in After-Ta Retirement Income Base case (Workers A & B) eample 8.0% Reslts for alternative assmptions Different ages: 25-year-old, saves 40 years 13.5% 55-year-old, saves 10 years 5.8% Different ta rates: 30% pre-, 20% post-retire (2.5%) 30% pre-, 22.5% post-retire 0.0% 30% pre-, 35% post-retire 14.2% Break-even ta differential by age: Age 25: 30% pre-, 18.2% post- 0.0% Age 55: 30% pre-, 24.5% post- 0.0% Different rates of retrn: 5% pre-, 5% post-retire 5.7% 10% pre-, 10% post-retire 10.2% Assmptions: Annal contribtions are assmed to be made in a lmp sm mid-year. Taable accont contribtions are assmed to eqal the taes not paid by avoiding Roth 401(k) contribtions and the reslting etra ta liability. Taes are paid pro-rata annally for all taable accont income and capital gains per the assmed taable accont average ta rate (20%). Annal withdrawals are assmed to be made in a lmp sm at the beginning of each year. Transaction costs are ignored. Any potential ftre adjstments (for inflation) after 2006 to the contribtion and catch-p limits have been ignored. income ta rate wold have to drop by more than 7.5% to a rate below 22.5% (i.e., a 25% drop in the rate of taation) before the net income from sing the traditional 401(k) wold prodce greater after-ta retirement income than the Roth. For yonger workers, the redction in the retirement income ta rate wold need to be far greater. Clearly, this level of difference is more than many workers are likely to eperience between now and retirement (more abot this later). The qestion of whether the Roth 401(k) really benefits only higher-paid workers may also be misleading. Most highly paid workers are in their 40s to 60s, typical peak earning years. However, frther analysis reveals that time also plays a big factor in who benefits from the Roth 401(k), and yonger workers have the advantage of more years of accmlation. Assme that in the eample above or two workers are age 25 and will be saving for 40 years (doble the previos amont of time). What difference wold this make in retirement income? All else being eqal, Worker B wold receive $306,449 annally dring retirement, while Worker A wold net $270,106, or $36,343 less annally and $908,583 less cmlatively over the 25-year retirement period. Also, the amonts saved in the Roth don t change the above benefit in percentage terms; in this eample or 25-year-old saving in the Roth will have 13.5% more after-ta income from any amont saved via the Roth 401(k). Table 2 provides a qick smmary of the reslts to or Workers A and B eample above for changes in the nderlying assmptions. As we have discssed, the two assmptions which have the greatest impact on reslts are the starting age of the worker (providing the nmber of years of savings accmlation) and the pre- and postretirement ta rates. Why Does the Roth 401(k) Offer Larger Benefits in Many Cases? In a Roth 401(k), Only the Contribtions Are Taed All of the Earnings Escape Taation Forever. In a traditional 401(k), both the contribtions and all earnings and even the earnings on any annal ta savings (see above eample) are eventally taed. So the Roth 401(k) offers lower total dollars sbject to taation, at the cost of having those contribtions taed p front. As the above analysis shows, this is often a good trade-off to make. 82
Roth 401(k) and Roth 403(b) Acconts: Year-by-Year Analysis of Roth 401(k) Advantage The previos analysis looked at the benefit of the Roth 401(k) choice verss a traditional 401(k) nder many different assmptions. Those comparisons calclated the benefit of the Roth 401(k) as a percentage improvement over the entire accmlation and distribtion periods. However, the decision to choose the Roth or traditional 401(k) is actally made on a year-by-year basis, as a participant can decide for each calendar year whether he or she wants to contribte to the Roth or traditional 401(k), or even divide his or her elective deferrals between those choices. Evalated as a series of calendar year decisions, the advantage of the Roth is even more dramatic than previosly shown. We analyzed the relative benefit of the Roth 401(k) vs. the traditional 401(k) on a year-by-year basis for a fictitios plan participant, starting at age 25, and for each year thereafter p to a planned retirement age of 65. In effect, the analysis measres the relative benefit of making the Roth election vs. the traditional election in each of those 40 years individally. All other assmptions of the analysis are the base case assmptions described earlier. The reslts are shown in Figre 1. By choosing the Roth, the 45-year-old mid-career professional gains a 10.9% advantage in retirement income prodced by the single calendar year of elective deferrals dring his 45th year of age. That compares to an average 8.0% benefit to the Roth over the entire 20 years of accmlation ntil retirement at age 65. The 25- year-old new hire sees a 17.3% advantage by choosing the Roth in his 25th year of age, vs. a 13.5% average Roth advantage over a 40-year accmlation period. For participants of all ages, the Roth advantage diminishes very slowly with each scceeding year (at the rate of abot 0.3-0.4 percentage points per year), bt even the seasoned employee at age 60, with only five years to retirement, gains a 5.4% advantage for selecting the Roth for that one year in which he trns 60. We can also analyze the effects of an assmed differential in ta rates dring working years vs. retirement, and ask at what point, for each calendar year of accmlation, does the assmed ta differential between that year of accmlation and the participant s marginal ta rate in retirement eliminate completely the Roth advantage. The reqired differentials to have eqal retirement payots from either the Roth or traditional 401(k) are shown in Figre 2. For the 45-year-old mid-career worker with a crrent income ta rate of 30%, the marginal ta rate in retirement wold have to fall at least 9.8 percentage points, to 20.2%, before the 10.9% retirement income advantage of the Roth contribtions in that 45th year is eliminated. For the 25-year-old worker, the ta rate wold need to drop 14.8 percentage points to 15.2%, nearly a 50% redction in the rate of taation! Figre 3 reveals the impact of age and ta-rate drops in retirement in combination. The lines on the chart are essentially isometric lines of eqivalent advantage of the Roth vs. traditional 401(k) contribtions across different participant ages and changes in ta rate in retirement. This chart assmes a 30% ta rate dring accmlation years; for a 40% ta rate assmption, the isometric lines all shift down abot 2-3 percentage points, so that the Roth alternative improves by an additional 2-3% at all points across the chart. We can conclde from the chart that a 25-yearold worker is almost always better off with the Roth, since a hge and nlikely drop in ta rates wold have to occr to eliminate the advantage. Even for a late mid-career professional at 55, the ta rate wold have to drop 6.8% in retirement to lose the Roth advantage. In fact, we can observe that for each year a participant ages, the ta rate FIGURE 1 Roth 401(k) Advantage vs. Traditional 401(k) 20.0% 18.0% Roth Advantage (%) 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 25 30 35 40 45 50 55 60 64 Age of participant Incremental annity income (from contribtions in year participant achieves stated age) 83
Roth 401(k) and Roth 403(b) Acconts: Drop in Ta Rate at Retirement (%) Drop in Ta Rate (%) 15 10 5 0-5 -10-15 -20-25 drop in retirement mst diminish an additional 0.3 percentage points to maintain the same Roth advantage as calclated for the immediately preceding calendar year. Ta Rates dring Accmlation and Retirement Years How likely is it that a participant s ta rate will drop in retirement compared to what it is dring his or her FIGURE 3 Roth 401(k) Advantage vs. Age and Drop in Ta Rate FIGURE 2 Roth vs. Traditional 401(k): Breakeven Point per Change in Ta Rate at Retirement by Age of Contribtion 0.0% -2.0% -4.0% Roth 401(k) is Better -3.7% -6.8% -6.0% -8.0% -10.0% -9.8% -12.5% -12.0% Traditional 401(k) is Better 14.8% -14.0% -16.0% 25 35 45 55 65 Age Breakeven Point 25 35 45 55 64 Age % Advantage/ (Disadvan.) to Roth: 15% 10% 5% 0% -5% -10% working years? In most cases, it will drop significantly less than one might epect, and in some cases the ta rate in retirement might actally increase. Table 3 shows some eamples for participants of different ages and at different levels of income. The Federal and California state income ta rates are applied as they eist for 2006, and inflation is ignored. The reslts are shown in Table 3. Even with big drops in earned income, most tapayers of at least moderate means will see only modest drops in ta rates becase most ta rate schedles get to high marginal ta rates with relatively small amonts of income. The 25-year-old worker is likely to see no drop in ta rates in retirement, and in fact will probably see a ta rate increase. Assming the worker sees salary increases over most of his career, his ta rates will probably increase over his lifetime, and then perhaps decline from those peaks in retirement, bt retirement income and ta rates are likely to eceed those dring his early working years of lower salary. The mid-career professional also sees no decline in ta rates even with a 33% drop in income. The higherearning late-career professional will likely see the biggest drop in taable income bt will probably stay in a relatively high ta bracket even if his or her income is ct in half. In or eample, that worker might epect p to a 4.5% drop in ta rates. If any of these workers choose not to se the Roth 401(k), then any distribtions from the 401(k) accont will be added on to their other taable income, redcing the likelihood of a significant drop in ta rates. It is the worker choosing Roth contribtions, whose distribtions will not be inclded in taable income, that is more likely to see drops in ta rates in retirement. Crrent marginal ordinary income ta rates are significantly lower now (3-5% lower for federal at eqivalent inflation-adjsted incomes) than they have been at any time over the last 10 years. With large federal bdget deficits and higher costs for entitlement programs inclding Social Secrity and Medicare, it is nlikely that ta rates will stay as low as they are now for the remainder of or working lives and well into retirement. Frthermore, government sorces of revene cold change in the ftre as additional income is needed to meet these obligations. Congress cold try to change the rles on Roth withdrawals and decide to ta at least a portion of any distribtion, althogh given historical precedence, they wold likely grandfather any eisting assets 84
Roth 401(k) and Roth 403(b) Acconts: in Roths. This search for additional revene, however, woldn t necessarily eempt Roth assets if, for eample, revenes were generated via a national sales ta. One additional caveat to the above discssion: since crrent taable income will be higher sing the Roth 401(k) option, pper-income workers cold hit the phaseot of itemized dedctions faster, ths losing some ta advantage. The ta effects shold be reviewed with a ta professional for these clients before choosing between a Roth and traditional 401(k). Strategies for Use of a Roth 401(k) The bigger isse for yonger or lower-paid workers is whether or not they can afford to pay the taes p front on contribtions made to the Roth 401(k). Yonger workers may not have reached their peak earnings potential and are often living on tighter bdgets. The ability to split contribtions between traditional and Roth 401(k) acconts (if offered by the plan sponsor) provides great fleibility for these workers to tailor their retirement savings to their personal sitation. Additionally, since workers can change their deferral decisions between the Roth and traditional 401(k) at least annally, they cold weight their contribtions more heavily to the Roth if they anticipate a lower income year (and ths, lower marginal ta rates), or the traditional 401(k) if they epect a higher income year. Participants at all income levels may also consider sing a Roth 401(k) to help manage against ftre nknowns. One major assmption of or analysis is the anticipated taation rate years down the road. Since this is nknown, the Roth 401(k) option provides plan participants of all income levels with one of the best hedges against ftre income ta rate increases. The eistence of Roth accont retirement savings allows a greater degree of control over taable income in any given year, allowing retirees to more effectively control all sorces of taable income (capital gains, dividends, etc.) even if earned income is no longer in the pictre. Frthermore, since Social Secrity benefits become partially taable above a certain income, Roth withdrawals which aren t conted as income won t place Social Secrity benefits at risk of taation, ths providing dal sorces of potentially ta-free income. Another benefit is that the Roth s ta-free withdrawals can help highly paid workers manage their ta sitation in retirement. These workers, who often already have significant assets in a traditional 401(k) plan, will be able TABLE 3 Will Ta Rates Be Lower in Retirement? Early-Career Mid-Career Late-Career (single) (married) (married) Age 25 45 60 Earned income $70,000 $150,000 $300,000 Dedctions, eclsions ($6,000) ($30,000) ($60,000) Taable income $64,000 $120,000 $240,000 Marginal ta rates on taable income Federal 25.0% 25.0% 33.0% State (CA) 9.3% 9.3% 9.3% Combined 32.0% 32.0% 39.2% Retirement taable income (assmed) $60,000 $100,000 $125,000 Percent drop from earned income to retirement taable income -14.3% -33.3% -58.3% Marginal ta rates on taable income in retirement Federal 25.0% 25.0% 28.0% State (CA) 9.3% 9.3% 9.3% Combined a 32.0% 32.0% 34.7% Ta rate drop in retirement 0.0% 0.0% -4.5% Roth 401(k) advantage 17.3% 10.0% 0.0% a State taes dedctible from federal taes. Ta rates assme no change in marital stats. 85
Roth 401(k) and Roth 403(b) Acconts: % Increase in After-Ta Retirement Income to withdraw a portion of their retirement income from a Roth 401(k), thereby lowering their overall ta brden. Workers lcky enogh to have accmlated sfficient assets and/or enjoy a retirement pension that meets their lifetime income needs can take advantage of another benefit niqe to the Roth. Roth 401(k) assets may be rolled ot of a Roth 401(k) plan at retirement or separation from service and transferred into a Roth IRA. Once in a Roth IRA, those assets are free of the reqirement to start reqired minimm distribtions at age 70 1 2, allowing the accont holder many more years of ta-free growth. If not sed dring life, and left as an inheritance to children or grandchildren, these assets cold provide ta-free growth and income for 70 years or more. Traditional 401(k) balances, whether left in a company 401(k) plan or rolled over into an IRA, are sbject to minimm reqired distribtions starting at age 70 1 2. Allocation of Investments between Traditional 401(k) and Roth 401(k) Acconts The fact that earnings within traditional 401(k) acconts will ltimately be taed and that earnings within Roth 401(k) acconts will not be taed sggests that there might be an optimm decision on how to allocate investment choices between the two types of acconts. Indeed, we might believe that it wold be best 20.0% 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% FIGURE 4 Roth 401(k) Advantage - Best Assets in Roth 25 35 45 55 64 Age 9% Roth retrn, 30% ta 9% Roth retrn, 40% ta 10% Roth retrn, 30% ta 10% Roth retrn, 40% ta to take advantage of the ta-free natre of the Roth to hold those assets with the highest total retrn potential, and hold those assets with lower total retrn possibilities in the ta-deferred 401(k) accont. That wold allow s to maimize the after-ta total distribtions. Figre 4 shows the incremental benefit in after-ta retirement income, as a fnction of the participant s age and marginal ta rate, by segregating assets between acconts. Assme a total retrn from the combination of all Roth and traditional 401(k) acconts of 7.5% annally. In this scenario, some assets earn a retrn as high as 9% annally, meaning that some assets mst earn retrns lower than 7.5%. This eample also assmes that at the start of the analysis, 20% of total 401(k) assets are in Roth 401(k) acconts and 80% in traditional 401(k) acconts, a reasonable assmption since Roth 401(k) acconts are new and traditional 401(k) assets cannot be transferred into them. This means that at the start, the traditional 401(k) accont has an implied annal retrn on its assets of 7.125%. These assmptions ensre that the overall retrn on both acconts totals 7.5%, allowing isolation of the impact of the allocation decision between acconts, while fiing the total retrn and total allocation across both acconts. The Roth 401(k) becomes a growing percentage of the total 401(k) assets over time, as it grows at a faster 9% constant rate, while the traditional 401(k) accont grows at a slower rate and the overall retrn across all 401(k) balances is held constant at 7.5% annally. No new plan contribtions are made dring the analysis period. A 45-year-old worker with 20% of total 401(k) assets in a Roth accont and a 30% ta rate cold epect a 2.52% increase in after-ta income from eisting balances across both 401(k) acconts by preferentially placing the higher retrning assets in the Roth 401(k) rather than holding identical secrities in each accont. That advantage increases to 3.76% if the worker has a 40% ta rate. The 25-year-old worker sees a slightly larger increase by making this allocation decision an increase in total after-ta distribtions from eisting plan balances of 5.85% or 8.71%, respectively, for the two ta rates. A 55-year-old worker retiring in 10 years wold see only a tiny increase in retirement income. If the retrn on assets placed in the Roth accont averages a higher 10%, still holding the overall retrn at 7.5% across both Traditional and Roth acconts, the increase in income 86
Roth 401(k) and Roth 403(b) Acconts: is sbstantially higher as shown in Figre 4. What if the participant gesses wrong and the assets allocated to the Roth 401(k) accont earn less than the overall accont? If a 45-year-old worker prchased assets in the Roth that retrned only 6% on average annally, while the remainder of the traditional 401(k) earned 7.875% annally (so total retrn across all 401(k) assets is still 7.5%,) then the retirement after-ta payots wold be 1.93% less than if the assets had been allocated eqivalently across Roth and traditional acconts. Preferentially allocating assets that historically have delivered higher retrns to the Roth is a good bet in this scenario a 2.52% likely advantage vs. an nlikely risk of a 1.93% disadvantage if the participant is wrong. Althogh these increases are very modest, it mst be remembered that they come on top of the advantage calclated earlier for Roth contribtions, and that they represent an incremental retrn at no increase in overall risk or cost. Frthermore, the asset allocation advantage is one that only comes if the Roth choice is invoked at all; withot a Roth, there is no ta-free accont in which a participant can preferentially hold the higher-retrning assets. Isses for Plan Sponsors The biggest decision for self-employed individals and company sponsors of 401(k) plans is whether and when to add this featre. Introdction of the Roth 401(k) choice to an eisting 401(k) plan presents a nmber of potential problems and concerns for plan sponsors. First and foremost, the software and acconting treatment to split taable Roth contribtions from nontaable traditional contribtions, matching employer contribtions, and forfeitres mst be in place with the plan record keeper. In addition, the employer s payroll systems (or those of the payroll service provider) mst be reprogrammed to correctly handle taable and nontaable employee deferrals. Participant statements mst be pdated to separate Roth from traditional acconts, inclding the fact that the investment elections in each of the two acconts may be different. Plan enrollment forms mst be pdated, as well as the telephonic or online systems allowing participants to select deferral amonts and investment choices. Finally, the plan docments mst be edited to inclde the proper amendment langage to adopt the Roth featre. Preapproved prototype langage has not yet been pblished by the IRS, althogh they have stated that Roth featres may be introdced now and enabling langage can be incorporated in the plan docments no later than the end of 2006 to permit Roth participation in 2006. All of these isses involve sbstantial changes, reqiring time and perhaps additional epense. Perhaps the most inhibiting aspect of Roth introdction is the concern abot how to edcate participants so that they make good decisions withot overwhelming them with choices and information in sch a way that paralyzes them or actally inhibits participation in the plan. Most plan sponsors are well aware of the risks of giving plan participants too many choices, often leading to a failre to make any at all. However, it is important to recognize that Roth deferrals are simply an option within the plan, one that an employee who remains ncertain or confsed can simply ignore for now and come back to at a later date. Or eperience shows that in almost any company, a significant segment of employees will nderstand this new featre and its benefits immediately, and will elect to make Roth deferrals as soon as they are eligible. If it is not already offered, they will demand it. The potential benefit of the Roth 401(k) is significant to large nmbers of plan participants. The ability to increase retirement income, with no increase in either risk or investing costs, is a powerfl reason to find ways to ct throgh the compleity and encorage participants to nderstand and make a proactive choice for the Roth or traditional deferrals. Althogh the modeling of potential otcomes amid nmeros variables is comple, the conclsions are not, and they can be easily smmarized in a single chart sch as that shown in Figre 3. With some annal gidance, most participants shold be able to find themselves on that chart and make the proper elections each year. Plan sponsors have also epressed some concern abot the snset provision that crrently becomes effective in 2011. As mentioned earlier, in or opinion Congress is nlikely to let this provision epire completely, especially as they focs increased efforts on shoring p retirement assets for workers, and as the national savings rate hovers near 0%. Congress needs to provide better incentives for workers to save for their own retirements, and the Roth 401(k) is a great step in the right direction. In any event, there are 87
Roth 401(k) and Roth 403(b) Acconts: still five years of potential Roth 401(k) accmlations for employees between now and the end of 2010. Finally, there has been some relctance to offer the Roth option to 401(k) participants on the part of small and mid-sized companies ntil they see it adopted by larger companies. Most plan administrators and payroll service providers have been gearing p to be able to accommodate Roth 401(k) contribtions, althogh in late 2005, only 34% of 223 large employers srveyed by Hewitt Associates said they were likely to add Roth 401(k) plans to their employee retirement options this year. In late Febrary of this year, General Motors Corp., atomotive spplier Delphi Corp., Vangard Grop Inc., and A.G. Edwards Inc. annonced plans to allow their workers to make elective contribtions to a Roth 401(k) starting no later than mid-year. Major corporations like these cold spr others to adopt sch plans more qickly. And as corporate giants sch as IBM scale back traditional employee pensions in favor of definedcontribtion plans, employers will need to offer the most competitive benefits and options in order to attract talent in an increasingly competitive environment. In an era of diminished epectations that workers will be able to receive the fll Social Secrity benefits they have come to epect and the willingness of employers to redce their contribtions to corporate pension plans for employees, certainly it is not too mch to ask that organizations and corporations flly embrace immediately the Roth 401(k) option that Congress has offered workers to save for their own retirement. The ability to make elective deferrals in a 401(k) or 403(b) plan on a Roth basis is one of the most powerfl retirement savings options ever created by Congress. Sponsors who are trly concerned abot managing their retirement plan for the greatest benefit of all participants wold be wise to add this featre as soon as possible. David J. Campbell, CFA, principal, Bingham, Osborn & Scarborogh, LLC, San Francisco, CA. He provides investment advice, portfolio design and financial planning for private and instittional clients, and condcts research on the technology and U.S. real estate markets. He earned a BA, with distinction, from Stanford University, and an MBA from the University of California, Berkeley. His bsiness eperience incldes 10 years with Charles Schwab & Co., Inc., in a variety of positions. He has been with Bingham, Osborn & Scarborogh LLC since 1994. Dave has provided technical analysis and advice for several articles in leading bsiness pblications sch as Barron s and SmartMoney magazine, served as a technical editor for Eric Schrenberg s 401(k) Take Charge of Yor Ftre, and has appeared in personal finance and investment segments on the NewsNet Central and KRON Channel 4 television networks. He may be reached at dave.campbell@bosinvest.com. William R. Urban, CFP, CFA, principal, Bingham, Osborn & Scarborogh, LLC, San Francisco, CA. He provides investment advice, portfolio design and financial planning services for private clients and nonprofit endowments, and manages the firm s Menlo Park office. His bsiness eperience incldes 13 years in sales and financial marketing management at IBM and Teas Instrments. He earned a BA from Princeton University, an MS from the University of Sothern California, and an MBA from Stanford University. He has been widely qoted in leading pblications sch as the Wall Street Jornal, the San Francisco Chronicle, the San Jose Mercry News, and MONEY magazine. Bill served as technical editor for Personal Finance for Dmmies and Mtal Fnds for Dmmies, by Eric Tyson, 3rd editions. Bill has also been pblished in the trade pblication Investment Advisor on the topic of ethical responsibilities of investment advisers. He may be reached at bill.rban@bosinvest.com. 88