THE
ROTH 401(K) - AN ACTUARIAL VIEWPOINT
By
David Teitelbaum, E.A.
As the January 1, 2006 rollout date for
the Roth 401(k) approaches, plan sponsors can expect to receive a
blizzard of information about this new option. Included in that
information will be some excellent summaries of the provisions of
this new option, generally offered in the context of comparisons
between “Roth” and “Traditional” 401(k)
contributions. Amidst this blizzard of information, however, two
things are certain:
1)No
one will give you a simple concise answer to the only question
which matters to your participants; namely “should I put my
401(k) money into a Roth or a Traditional 401(k)?” and
2)In
the absence of a clear concise answer, plan participants will
make their decisions based on faulty premises and, in many cases,
arrive at faulty conclusions.
Unfortunately, I
am also not going to give you a simple “yes or no”
answer. As the standard disclaimer at the end of this article
states, the dispensing of tax advice is frowned upon by IRS and
the decision whether to choose Roth or Traditional 401(k) is
essentially a tax question. What I can do, however, is to provide
you with an actuary’s perspective of the key considerations
that apply when making this decision.
The number one difference between a Roth
and a Traditional 401(k) is in the timing of taxation. Under the
Roth, contributions are currently taxable and distributions,
including interest, are generally made tax free. Under a
Traditional 401(k), contributions and earnings are tax deferred
and are taxed upon distribution. Mathematically, the two are
identical for an individual who has a limited amount of money to
spend and who will be in the same tax bracket at retirement that
he is at today. Thus, to determine the instances when it would be
advantageous to pick one approach over the other, we need to look
at those situations when either a) an individual is not limited
in what he can invest, b) the individual’s tax bracket will
change, or c) one of the other differences between Roth and
Traditional 401(k) contributions apply.
We begin with an
analysis applicable only to an individual who, if he
could, would contribute much more than the maximum allowable
contribution:
ROTH VS.
TRADITIONAL FOR INDIVIDUALS AT THE MAXIMUM
Including:
1)Employees
who would like to contribute more than $15,000 to a 401(k) and
2)Highly
Compensated Employees who are limited in what they can contribute
to their company 401(k) because participation among Non-Highly
Compensated Employees is not sufficient to allow them to
contribute the maximum.
Suppose that an
individual who expects to always pay at least 40% in taxes has
$25,000 that he would happily put away in his 401(k) if he were
allowed to do so. Under the traditional 401(k), he can contribute
$15,000, pay $4,000 taxes on the remaining $10,000 and invest the
remaining $6,000 in a taxable investment (or receive a lower
yield in a tax free investment). Under the Roth, however, with
taxes paid up front, the individual would pay $10,000 in taxes
and the remaining $15,000 would grow tax free in the 401(k) plan.
CAI has designed
a spreadsheet calculator which shows clearly that under almost
any set of reasonable assumptions, this individual comes out
ahead in the Roth. Upon request, we would be glad to e-mail
this spreadsheet to you.
While the
spreadsheet is sufficient to prove the point about Roth generally
being better than Traditional for this individual, you will note
that I am an Actuary, and as such, I can’t resist taking a
few extra moments to explain in numbers and formulas why this is
so. For those of you who do not need to read a technical
analysis, please feel free to skip the next couple of paragraphs
and pick up again with the paragraph that begins with the words
“of course.”
For those of you
who are not afraid to follow an actuary into the wilderness,
perhaps the best way to approach the analysis is to divide the
$15,000 Roth deposit into two separate accounts. – one
account with $9,000, the other with $6,000. We then compare these
two accounts to their Traditional 401(k) counterparts:
1)The
$9,000 Roth vs. the $15,000 Traditional: Assuming that the
participant remains in a 40% tax bracket, and assuming that this
Roth account is distributed at the same time as the Traditional
account generated by the $15,000 contribution, the value of the
two upon distribution will be identical. Mathematically, $15,000
invested to earn X% per year with 60% left over after taxes are
paid, is the same as $9,000 (i.e 60% of $15,000) invested to earn
X% for the same period. ADVANTAGE: NONE
2)The
$6,000 Roth vs. the $6,000 after tax account: The Roth $6,000
account and earnings thereon are invested tax-free. The outside
$6,000 account is subject to income and capital gains taxes every
year. ADVANTAGE: ROTH
Overall
Conclusion: The total after tax accumulation is higher for
this individual if he elects to have his 401(k)
contributions treated as Roth 401(k).
Of course, there
are financial advisors who say that “a tax deferred is a tax
saved” and the many changes that have occurred in the U.S.
tax structure over the years have shown that these advisors have
a point. If future changes to tax law either a) reduce the tax on
distributions from traditional retirement plans and IRAs or b)
place a tax on Roth distributions, then all bets are off.
However, as the laws stand today, individuals who would like to
contribute the absolute maximum to their 401(k) plan, are likely
to do better in a Roth.
TAX BRACKET
CONSIDERATIONS
Predicting an
individual’s future tax bracket is, at best, an inexact
science. Its not just a matter of will your earnings be higher or
lower at retirement but you must also consider questions like
“will income tax rates be higher or lower in the future?”,
“will tax rates on investments be different from tax rates
on income?”, “what will be the tax rate in the state
that I am living in when distributions are made?”, and
even “will there even be an income tax in the future or will
it be replaced by something else?”. So does this mean that
your participants might as well toss a coin? To a point, yes, but
at least they can make sure that the coin is weighted somewhat in
their favor.
Individuals in
the Lowest Tax Bracket: Employees paying income taxes at the
lowest bracket have very little to lose by going with the Roth.
For these individuals, it is more likely that their tax rate will
be higher at retirement and even if it is not, the loss by
choosing the Roth will be insignificant.
Individuals in
a High Tax Bracket and close to retirement: An individual at
the peak of his earnings power who, upon retirement, will rely
primarily on social security and investments, will almost
certainly be in a lower tax bracket when he starts receiving
distributions. Assuming that this person cannot contribute the
maximum to the 401(k) (see “Individuals at the Maximum”
above), the Traditional 401(k) is more likely to be the right
choice. Why pay taxes at a higher rate now when you can pay at a
lower rate later?
OTHER
CONSIDERATIONS
5 Year Minimum
for tax free distributions: The Roth only becomes a Roth for
funds that are still in the plan 5 years after you first began
contributing. Thus, a participant who makes his first Roth
contribution on January 1, 2006, can begin receiving tax-free
distributions after January 1, 2011. On the other hand, if the
first contribution is not made until January 1, 2009, he will
have to wait until at least January 1, 2014. Subject to revisions
in the final regulations, this provision is an argument in favor
of contributing something to the Roth with the first eligible
payroll and then making their own personal decisions as to which
401(k) is best for them.
Matching
Contributions for employees with limited resources: This is
the converse situation to the “Individuals at the Maximum”
described above. Suppose that a company will match 50% on the
first 6% of pay that a participant contributes. The employee has
been contributing the 6% to his traditional 401(k) but he doesn’t
have another dollar to spend. Assuming the employee is in a 25%
tax bracket, if that employee were to elect the Roth, he would
have to pay taxes on the full 6% of pay, leaving him with only
4.5% of pay left to go into the plan. As a result, his match
would drop from the maximum of 3% of pay down to 2.25% of pay.
Thus the standard rule of “always contribute the amount
needed to get the maximum match” is invoked and the
participant should stick with the Traditional 401(k).
Expenses: While
most service providers have indicated that their systems will
allow for Roth 401(k) contributions as soon as possible, few have
indicated what the cost of implementing this option will be. In
plans where expenses are charged to participants, it will be
important to know whether or not selecting the Roth will cause
the participant to incur a higher expense than those who do not
select Roth. If so, it may not be worth it.
Minimum
Distributions: There is currently some confusion concerning
how the Minimum Distribution rules will relate to Roth 401(k)
money. The current assumption is after Roth 401(k) money is
rolled to a Roth IRA, it will be exempt from the Minimum
Distribution requirements while the participant is alive. Thus,
if these rules are finalized as is, an individual looking to
defer minimum distributions beyond age 70 1/2 will have an
additional reason to consider choosing the Roth.
SUMMARY AND
FINAL ADVICE TO PLAN ADMINISTRATORS
The decision as
to whether to elect Roth or Traditional involves complex
mathematics, economic modeling, and an intricate knowledge of
current and future tax policy. The good news, though, is that for
the great majority of plan participants, the choice between
Roth and Traditional is far less important than the choice as to
how much to contribute to the 401(k) plan and how those funds
should be invested. If your head is spinning from all the
information you receive on the Roth 401(k) just keep in mind
that, in the overall picture, the decision is likely to be a
relatively unimportant one.
And of course, as with all decisions that
plan participants must make, it is strongly recommended that plan
administrators avoid providing either investment or tax advice.
If, however, you must say something, and if it is put in writing,
make sure that you end with a statement similar to the statement
printed below which is also applicable to everything contained in
this article.
To ensure compliance with requirements
imposed by the IRS, we inform you that to the extent anything
herein is considered to be tax advice, it is not intended nor can
it be used for the purpose of (i) avoiding penalties under the
Internal Revenue Code or (ii) promoting, marketing, or
recommending to another party any transaction or matter addressed
herein.
Note: The author of this article, David
Teitelbaum, is CEO of Consulting Actuaries Incorporated in
Fairfield, New Jersey and is an Enrolled Actuary.
