Pre-tax saving is not as beneficial as it once was, and plan sponsors should begin to educate participants on the importance of "tax diversification" in their defined contribution plans with the debut of the Roth 401(k).
For more than 20 years, the tax thinking underlying 401(k) and 403(b) plans has been pretty simple: save on taxes today with pre-tax contributions when tax rates are presumably higher, and pay taxes tomorrow, in retirement, when tax rates are likely to be lower.
But on Jan. 1, this simple paradigm will be turned on its head. From that date, sponsors will have the option of offering a Roth feature in their retirement savings plans, allowing participants to diversify tax risk and maximize after-tax income in retirement.
If the Roth feature is offered, participants will be able to make their contributions on a pre-tax basis, an after-tax Roth basis, or some combination of the two. In retirement, they will be able to withdraw all Roth monies tax free so long as they are over age 59%BD; and their account has been opened for five years.
"Never pay taxes again" will be the Roth rallying cry.
The conventional view is that the Roth 401(k) will benefit only a few participants, mostly the affluent, who can't take advantage of the Roth individual retirement account. But the Roth can also help many rank-and-file participants.
With recent changes to the tax code, pre-tax saving is simply not as advantageous as it was. In today's world of flatter tax rates, any participant doing a good job of saving for retirement is likely to be in the same tax bracket in retirement as he or she is today. With a meaningful pool of pre-tax assets to their name (and perhaps pre-tax income from a pension), participants are justifiably worried about the chances of higher taxes in retirement.
A rank-and-file group that should consider the Roth consists of the many individuals paying a low (10% or 15%) marginal tax rate today. Especially important in this group are young individuals who anticipate large future gains in their income, and thus large future gains in tax rates. With the Roth feature, they could lock in a low tax rate today for a lifetime.
Among the better paid, consider a 55-year-old employee in the 35% tax bracket who invests the maximum $20,000 on a Roth basis in 2006. That's $20,000 (plus any future investment earnings) available tax-free in retirement. By comparison, if the participant invests $20,000 on a pre-tax basis, he or she will owe taxes on the $20,000 contribution — and on all future earnings — in retirement. With the introduction of the Roth 401(k), Congress has dramatically expanded tax-sheltered savings opportunities for those contributing at the legal limit. In fact, the participant would have to contribute nearly $30,800 on a pre-tax basis (if allowed by law) to achieve results similar to the Roth 401(k).
The well-prepared face another challenge — taxes on Social Security benefits once they retire. At certain income levels, pre-tax withdrawals accelerate the taxes due on Social Security. For example, a middle-income couple earning $80,000 today is in the 15% tax bracket (with standard deductions and exemptions). If the couple retires on 75% of their income, their marginal tax rate in retirement will soar to 28%, as pre-tax withdrawals trigger higher taxes on Social Security benefits.
How will participants and sponsors sort out the right choice? The good news is that we will not need to arm employees with a tax adviser in order to participate in a 401(k) plan. Rather, the concept of tax diversification needs to be communicated, building on the already familiar notion of investment diversification. Just as participants diversify the risks of equities by holding fixed-income assets, so they should diversify the tax risks associated with pre-tax savings by holding Roth money as well.
Tax diversification recognizes the inevitable uncertainty of future tax rates. No one knows whether tax rates will be higher or lower in the future — participants don't know, nor do professional tax advisers, the Internal Revenue Service, government economists or congressional tax experts. In the face of this tax risk, many participants shouldn't respond by placing all of their tax eggs in a single pre-tax basket. Instead they should diversify, holding both Roth and pre-tax savings in their retirement accounts.
Initially it will be slow going for plan sponsor adoption of the Roth 401(k), both because of the payroll and record-keeping complexities and, as with any new concept, simple inertia. Most sponsors should eventually adopt a Roth feature, although we anticipate it will take five years before most do. Participant adoption is likely to be slow — less because of the tax issues, and more because of the inertia we know governs all participant decision-making. Perhaps a quarter will adopt the feature within five years.
The Roth feature isn't likely to prompt sponsors to offer a different set of investment choices from the existing ones in a traditional 401(k) plan. Funds of both the Roth savings and traditional 401(k) will be pooled. But more research will need to be done on whether the participants in the Roth feature are better served by some different portfolio choices.
Company stock — which amounted to 28.6% of 401(k) assets among the largest corporate plans in 2004, according to Pensions & Investments data — receives a special tax treatment for the company if held in the pre-tax plan, an advantage not applicable to the Roth feature. But participants should still consider Roth for their diversified savings.
Whatever your view of the Roth, there's no doubt the tax environment will continue to change. The Roth provision is scheduled to be repealed in 2010, though our guess is that it will be extended. President Bush's tax-reform commission is contemplating a range of proposals to revamp the U.S. tax system. These events underscore the inherent uncertainty of future tax rates, and the likely advantages of tax diversification with the Roth 401(k).