President's proposal would make such accounts available January 1.
This May is the three-year anniversary of the Economic Growth Tax Relief and Reconciliation Act of 2001 (EGTRRA, passed May 26, 2001)-yet we still face another year-and-a-half before the newly designed provisions for a Roth 401(k) take effect on January 1, 2006. However, in President Bush's recent Fiscal Year 2005 budget, which included his proposed Lifetime Savings Accounts (LSAs), Retirement Savings Accounts (RSAs) and Employer Retirement Savings Accounts (ERSAs), he also proposed the creation of a Roth ERSA to begin effective January 1, 2005. This Roth ERSA would function identically to the Roth 401(k) created by EGTRRA. Consequently, it behooves the financial advisor to be aware of the relevant planning issues and implications surrounding the Roth 401(k)/ERSA, as the Roth ERSA could be here in less than a year.
The primary issue that an advisor must address with a client choosing between a Roth or "traditional" 401(k) is the same one that applies to Roth or traditional IRAs-a comparison of current versus future tax rates. As can be seen in the table, when tax rates are equivalent now and during retirement, the after-tax lump sum proceeds derived from either account are equivalent; when tax rates are lower in the future, the traditional 401(k) (which allows a tax deduction at current high rates, and withdrawals spread across future low rates) is best. The table also reveals that the obverse applies as well-current tax rates that are lower than future rates favor the Roth 401(k). (The relative outcomes of these three examples apply regardless of the time period, growth rate or magnitude of difference between tax rates.) Thus, the question really becomes an estimate (or educated guesstimate) about whether the client will most likely be in a higher or lower tax bracket in the future.
Traditional wisdom has held that clients are in higher tax brackets during their peak earning years and are in lower tax brackets during retirement, when earned income sources go away. This has been reinforced by a series of decreases in ordinary income tax rates over the past two decades. Current retirees-who may have very substantial balances in their retirement accounts that will create substantial withdrawals subject to ordinary income-are likely still "ahead" in this game, as earned income goes away and tax cuts continue. However, this appears not always to be the case; sometimes, retirement account accumulations are so substantial, and the expected standard of living at retirement is so high, that taxable income is maintained or even increased at retirement.
In addition, we currently are running record government deficits. If you believe that our economy will grow its way out of the deficits for the most part (as we essentially did with the Reagan-era deficits), then this may not be a concern. However, the alternative school of thought would suggest that the deficit spending we do now will need to be recovered by tax increases in the future (Creating Roth 401(k) actually increases current tax revenues as Roth contributions are still subject to income tax-but future tax revenues decrease due to the tax-free nature of earnings, thus increasing current tax revenues at the expense of future tax revenues). These future tax revenue insufficiencies, in addition to the financial insecurity in the Medicare and Social Security systems, may require (possibly substantial) future tax increases. If tax rates do in fact rise, then your client may be in a higher tax bracket in retirement, despite the fact that his or her earned income ceases. When this is compounded with high retirement account balances, particularly for clients who are higher income, more affluent and/or bigger savers, the "traditional wisdom" that tax rates will be lower in retirement is called into question. If we begin to believe that tax rates will be higher in retirement, the Roth 401(k) suddenly becomes much more appealing.
Unfortunately, implementation of the Roth 401(k) has problems of its own. Separate accounting is necessary for the Roth 401(k) accounts from their traditional 401(k) counterparts, leading to potential increases in administrative costs (particularly for employers that offer both options) and additional hassles and confusion for clients. Small businesses could potentially find the costs prohibitive and choose to offer only one option, which places an unfortunate burden on the employer to pick the "right" plan for all employees (although, inevitably, what is "right" for some will not be for others, creating potential employee dissatisfaction). However, even more unclear is how the offering of a Roth 401(k), or dual 401(k) plans, will integrate with the current actual deferral percentage (ADP) nondiscrimination tests for 401(k) plans that don't meet the safe harbor guidelines.
The issue here is that the ADP test is based on the amount of money actually deferred into the plan. However, the cost of such deferrals is higher to a Roth 401(k) because the participant must pay taxes in addition to the contribution. For example-if the participant earns $50,000 a year, but can only afford to defer $5,000 a year of pretax salary (because the remaining $45,000 of pretax salary covers taxes due on the $45,000 of earnings and for living expenses), then the traditional 401(k) contribution will be $5,000 but the Roth 401(k) contribution will be only $3,750 (assuming a 25% tax bracket). ADP testing will reflect the $3,750 contribution, and thus those that are not safe-harbor plans and subject to ADP testing potentially may face deferral restrictions for their highly compensated employees.
The bottom line is that the Roth 401(k) may be an extremely favorable new method of saving for individuals, particularly if you believe that tax rates will rise in the future. But implementing these new accounts may create some painful bumps and problems along the way. And if Bush gets his way, they may be on your doorstep by the end of the year, in the form of a Roth ERSA. Will you be prepared to advise your clients on their retirement plan options for next year?
Michael E. Kitces, MSFS, CFP, CLU, ChFC, is director of financial planning with Pinnacle Advisory Group in Columbia, Md.