News & Articles
“Get Ready for another Retirement Savings Plan”
July 01, 2006
by R. Patricia Grenier, CFP®, CSA
As of January 1 a new Retirement Savings Plan joined the sometimes-confusing myriad of retirement plan options: the Roth 401(k).
Any one considering this option has to ask themselves a simple question. Do you want to pay Uncle Sam now or later? Anyone anticipating they will be in a higher tax bracket at retirement may want to pay Uncle Sam now. While a Roth 401(k) is not right for everyone, many younger workers, individual or couples with large estates or parents and grandparents saving for children's college education will find them beneficial.
The Roth 401(k) is basically modeled after the Roth IRA. In its simplest form here is how it works: Contributions are made with after-tax dollars instead of pre-tax monies as in a traditional 401(k). This means that the participant has elected to irrevocably defer earnings after they have been taxed opting to pay Uncle Sam now instead of later. As in a traditional 401(k), the maximum contribution may not exceed $15,000 for 2006 ($20,000 if you are age 50 or older). Earnings and withdrawals are distributed completely tax-free provided withdrawals begin after age 59 ½ and that five years have passed from the date of the first contribution to the plan. Taxes and penalties are waived if a participant dies or is disabled, separates from service, the plan terminates or a distribution is mandated due to a divorce (QDRO order) or IRS levy. Participants must begin taking minimum distributions beginning April 1 of the year after they turn 70 ½. However, monies in a Roth 401(k) can be rolled into a Roth IRA if the participant leaves the employer, relieving the participant from ever taking minimum distributions.1 There are no income restrictions and a participant can make both pretax and after-tax contributions in the same year as long as they do not exceed the $15,000 or $20,000 contribution limit. (See chart below)
Here is a simple example of the power a Roth 401(k) has and what makes it such an attractive option. Assume one 50 year old saves $20,000 per year in a traditional pretax 401(k), while a second saves $20,000 after-tax in the new Roth 401(k). Assuming a 7% earnings rate, each investor in 15 years will have $500,000 in their accounts. But the pretax investor will owe taxes on his account - an astonishing $176,000 at the top 35% rate. Meanwhile, the Roth 401(k) investor will dance into retirement with a half-million dollar retirement account completely tax free.2
This tax-free growth is what differentiates the new Roth 401(k). As can be seen from the above example, the Roth investor has 50% more in spendable income. Of course, the Roth investor paid taxes on the $20,000 while working but the tax free growth and tax free withdrawals will more than make up for it.
Roth savings also offer a valuable estate planning benefit if you are concerned about the tax liability your heirs will face in the future. Beneficiaries of Roth savings will not owe taxes on qualified distributions. Investors can easily avoid the Required Minimum Distributions at age 70 ½ by simply rolling over the Roth 401(k) into a Roth IRA.
What better way to hedge our tax risk than with the Roth savings plans. We now have a new strategy to consider: tax diversification. Many people today are planning for retirement under the assumption that at retirement they will be in a lower tax bracket. But what if tax rates at that time are not lower? There is no guarantee that tax rates will be lower years from now. There is always a possibility that they will be higher.
Brackets today are flatter and wider, and so there is a good chance of being in the same tax bracket at retirement. This is especially true of investors with substantial assets of their own or who are receiving generous employer-provided benefits. It is also true for the many people in the 10% to 15% tax bracket today. Clearly the best strategy to lessen the risk of higher tax rates is to diversify. Holding retirement savings in both pretax and after-tax savings will hedge the risk that rates could be lower or higher.3
For younger workers, it is a "no brainer". Typically younger works fall into a lower bracket today and have decades to save for retirement. If they save for retirement, especially at the higher amounts afforded in the Roth 401(k), they almost certainly will be in a higher tax bracket when they begin withdrawals.
Older parents or grandparents saving for a child's college education can also benefit. If you have at least 5 years to go before the child attends college, and you will be at least 59 ½, you will be able to pull money from the Roth tax-free to pay for school bills. Whatever remains is your. Retirement accounts generally aren't counted as assets in federal financial-aid formulas, potentially helping a student obtain a larger amount of financial aid.4
Unfortunately, the benefits of the Roth 401(k) may be short lived unless Congress acts to extend the law which is scheduled to end in 2010. It is uncertain what will happen when the sunset provisions kick in potentially eliminating future contributions. As has been the case with many other tax law changes, more than likely the contributions made during the five years that the Roth 401(k) was available would simply continue to grow until the participant could make tax-free withdrawals.
1Ziesenheim, Financial Advisor, December 2005, pg 99-100
2Utkus, On Wall Street, January 2006, pg 56-57
3Urkus, On Wall Streer, January 2006, pg 56-57
4Wall Street Journal, December 17-18, 2005
Pat Grenier is a General Partner with BRP/Grenier Financial Services in Springfield, MA. Securities offered through Cadaret, Grant and Co., Inc., Member FINRA/SIPC. BRP/Grenier and Cadaret, Grant and Co., Inc. are separate entities.
Pat can be contacted by phone at (413) 736-6712, or email her at pat@brpgrenier.com
Plant your first seed today.
Call 413-736-6712 for an appointment.
You will be our guest for the first consultation.
