Introducing The Roth 401(k)

Nine years ago, Congress introduced a new savings tool for investors called the Roth IRA. This new version of an Individual Retirement Account was named after the Senator that was instrumental in its creation, and it offered substantial tax advantages to persons seeking to save for retirement. Effective Jan. 1, 2006, legislation extended the tax advantages of the Roth IRA to include 401(k) plans. The “Roth 401(k)” creates a new option for law firms offering 401(k) plans to partners and employees, and gives participants the opportunity to accumulate significant tax-free wealth during their lifetime.

History of the Roth Ira

Prior to 1986 there was only one type of IRA, which has now come to be known as a “traditional IRA.” Contributions to traditional IRAs were tax-deductible, but all contributions as well as accumulated earnings were subject to income taxes when withdrawn, usually at retirement. Limitations were set so that upper income earners may not be able to utilize them. Then, in 1986, Congress created the “nondeductible IRA,” which limited the deductibility of IRA contributions made by individuals who were covered by other retirement plans such as a 401(k) plan. Contri-butions to a nondeductible IRA were not tax-deductible, nor were they taxed later on upon withdrawal. However, accumulated earnings remained fully taxable at withdrawal. However, there were no limits based on income, so upper income earners could use them. The nondeductible IRA, therefore, is a traditional IRA without the attraction of an up-front tax deduction.

In 1998, Congress introduced the Roth option. Like the nondeductible IRA, Roth IRA contributions offer no up-front tax deduction, but the similarity ends there. Withdrawals from Roth IRAs, subject to certain limitations, are completely tax-free, including all accumulated earnings. For those individuals who invest their money wisely and generate enormous earnings on their original contributions, it could be a tax savings windfall. Additionally, legislation enables individuals to convert their traditional IRAs into Roth IRAs (subject to certain income limitations) by paying income tax on their accumulated traditional IRA balance before conversion. This strategy is very beneficial in a growing stock market, though it could backfire in a declining market.

In the final analysis, the advantages of Roth IRAs were so strong that Congress limited their availability to those individuals whose income falls below certain designated amounts. Individuals with higher income were ineligible, which remains the case today.

Introducing the Roth 401(k)

The Roth 401(k) is an optional feature that can be added to a firm's existing 401(k) plan, by amending the provisions of the plan document. At present, this option can be offered through 2010; it remains to be seen if Congress will extend the law beyond this date.

Much like the IRA scenario just discussed, plan participants will be able to elect to contribute to their “traditional” 401(k) account as before, and/or fund a new Roth 401(k) account. Traditional 401(k) contributions can continue to be made with pre-tax dollars, with all proceeds fully taxable at withdrawal. In the alternative, Roth contributions can be made with after-tax dollars, with the proceeds fully tax-free at withdrawal if certain conditions are met regarding the participant's age, and the longevity of the account. The participant can divide his or her contributions among the two options in any ratio desired.

So far, the rules follow those of the Roth IRA. However, there are two distinct advantages to the Roth 401(k):

1. In 2006, the maximum annual cotri-bution to a 401(k) plan (traditional and Roth combined) is $15,000, versus $4,000 for a Roth IRA. For individuals at least 50 years of age, the limits increase to $20,000 and $5,000 respectively. The higher Roth 401(k) limits substantially increase the potential to accumulate tax-free wealth; and
2. The income limits that greatly restrict one's eligibility to contribute to a Roth IRA do not apply to the Roth 401(k). So, many people who were previously denied access to Roth tax advantages through an IRA, will now find them accessible through a 401(k) plan. But, as a tradeoff for this enhanced access, the law prohibits conversion of a traditional 401(k) balance to a Roth 401(k) balance even though this is permitted for Roth IRA plans.

The Roth 401(k) also presents an estate planning opportunity. While the law provides that individuals must begin receiving distributions from their Roth 401(k) accounts no later than at age 70 ?, no such requirement exists for Roth IRA accounts. Since under current law Roth 401(k) funds can be “rolled” into a Roth IRA, this presents an opportunity to circumvent the required minimum distribution rules. Thus, more wealth would be available to pass to future generations.

With opportunity often comes risk, and it's only fair to point out a risk inherent in Roth plans of any nature. Since Roth contributions are funded with after-tax dollars, it is possible to make an investment that subsequently loses most or all of its value ' yet all income tax will have already been paid and is lost as well. Say, for example, you contribute $15,000 to a traditional 401(k) account. If you are in the 40% tax bracket, you will save $6,000 in taxes, so that if the $15,000 investment is subsequently lost, your true net loss is only $9,000. Conversely, losing a $15,000 Roth-funded investment (made with after-tax dollars) would in fact cost you the full $15,000. It might be argued that riskier investments are better suited to a traditional 401(k) account, and more conservative investments should be directed to a Roth account.

Employer Costs and Benefits

There are certain costs specific to adding a Roth 401(k) option to an existing plan. First, the plan document must be amended by the administrator. Next, partners and employees must be educated about the features of the new option so that informed choices can be made by all. Lastly, there will be higher ongoing administrative costs since many participants will have multiple forms of salary withheld (for pretax and after-tax contributions), and multiple account balances to keep track of.

Incurring such costs may viewed as a savvy investment by a firm choosing to offer the Roth option, since enormous goodwill is promoted by presenting everyone, partners and employees alike, with a new opportunity to accumulate tax-free wealth over the course of a career.

Unfortunately it is possible, based on rules designed to prevent plans from discriminating in favor of highly compensated participants, that not everyone, especially partners, will be permitted to make the maximum contribution that would ordinarily be permitted. Presumably, however, the strong merits of the Roth option will attract firm-wide participation, which would serve to minimize the chances of having a problem with satisfying the antidiscrimination rules.

Contributing to a Roth 401(k) v. A Traditional 401(k)

Let us now consider a hypothetical example of how a Roth 401(k) might benefit an employee/partner. Assume a 40% income tax bracket and a contribution of $15,000 to a Roth 401(k) plan in 2006. Does it make sense to pay $6,000 tax today ($15,000 x 40%) to make a Roth contribution, as opposed to a traditional one? If one earns a modest 6% per year for 25 years, the investment will grow to about $67,000. An increase to 9% will yield $141,000 in 25 years. Would someone pay $6,000 today to have accumulated earnings of $126,000 ($141,000 – $15,000) be fully tax-free at retirement? Now, consider repeating this scenario annually rather than doing it just once, and the true potential of the Roth becomes clear.

The 25-year timeline demonstrates that in general, there is more “upside” potential for younger Roth participants, and more risk for older participants. The younger a participant is, the more years there are for investments to grow tax-free, the more time there is to recover from a poor investment, and the more opportunities there will be to contribute to the plan ' if the law is extended beyond 2010. Additional factors to consider include one's age, risk tolerance, cash needs, projected rates of return on investments, and income tax brackets both now and at retirement.

If the law firm chooses to add the Roth option to its 401(k) plan, partners and employees will want to plan carefully, to ensure that their decision will be an informed one, suited to their needs, expectations and specific situation.

Nine years ago, Congress introduced a new savings tool for investors called the Roth IRA. This new version of an Individual Retirement Account was named after the Senator that was instrumental in its creation, and it offered substantial tax advantages to persons seeking to save for retirement. Effective Jan. 1, 2006, legislation extended the tax advantages of the Roth IRA to include 401(k) plans. The “Roth 401(k)” creates a new option for law firms offering 401(k) plans to partners and employees, and gives participants the opportunity to accumulate significant tax-free wealth during their lifetime.

History of the Roth Ira

Prior to 1986 there was only one type of IRA, which has now come to be known as a “traditional IRA.” Contributions to traditional IRAs were tax-deductible, but all contributions as well as accumulated earnings were subject to income taxes when withdrawn, usually at retirement. Limitations were set so that upper income earners may not be able to utilize them. Then, in 1986, Congress created the “nondeductible IRA,” which limited the deductibility of IRA contributions made by individuals who were covered by other retirement plans such as a 401(k) plan. Contri-butions to a nondeductible IRA were not tax-deductible, nor were they taxed later on upon withdrawal. However, accumulated earnings remained fully taxable at withdrawal. However, there were no limits based on income, so upper income earners could use them. The nondeductible IRA, therefore, is a traditional IRA without the attraction of an up-front tax deduction.

In 1998, Congress introduced the Roth option. Like the nondeductible IRA, Roth IRA contributions offer no up-front tax deduction, but the similarity ends there. Withdrawals from Roth IRAs, subject to certain limitations, are completely tax-free, including all accumulated earnings. For those individuals who invest their money wisely and generate enormous earnings on their original contributions, it could be a tax savings windfall. Additionally, legislation enables individuals to convert their traditional IRAs into Roth IRAs (subject to certain income limitations) by paying income tax on their accumulated traditional IRA balance before conversion. This strategy is very beneficial in a growing stock market, though it could backfire in a declining market.

In the final analysis, the advantages of Roth IRAs were so strong that Congress limited their availability to those individuals whose income falls below certain designated amounts. Individuals with higher income were ineligible, which remains the case today.

Introducing the Roth 401(k)

The Roth 401(k) is an optional feature that can be added to a firm's existing 401(k) plan, by amending the provisions of the plan document. At present, this option can be offered through 2010; it remains to be seen if Congress will extend the law beyond this date.

Much like the IRA scenario just discussed, plan participants will be able to elect to contribute to their “traditional” 401(k) account as before, and/or fund a new Roth 401(k) account. Traditional 401(k) contributions can continue to be made with pre-tax dollars, with all proceeds fully taxable at withdrawal. In the alternative, Roth contributions can be made with after-tax dollars, with the proceeds fully tax-free at withdrawal if certain conditions are met regarding the participant's age, and the longevity of the account. The participant can divide his or her contributions among the two options in any ratio desired.

So far, the rules follow those of the Roth IRA. However, there are two distinct advantages to the Roth 401(k):

1. In 2006, the maximum annual cotri-bution to a 401(k) plan (traditional and Roth combined) is $15,000, versus $4,000 for a Roth IRA. For individuals at least 50 years of age, the limits increase to $20,000 and $5,000 respectively. The higher Roth 401(k) limits substantially increase the potential to accumulate tax-free wealth; and
2. The income limits that greatly restrict one's eligibility to contribute to a Roth IRA do not apply to the Roth 401(k). So, many people who were previously denied access to Roth tax advantages through an IRA, will now find them accessible through a 401(k) plan. But, as a tradeoff for this enhanced access, the law prohibits conversion of a traditional 401(k) balance to a Roth 401(k) balance even though this is permitted for Roth IRA plans.

The Roth 401(k) also presents an estate planning opportunity. While the law provides that individuals must begin receiving distributions from their Roth 401(k) accounts no later than at age 70 ?, no such requirement exists for Roth IRA accounts. Since under current law Roth 401(k) funds can be “rolled” into a Roth IRA, this presents an opportunity to circumvent the required minimum distribution rules. Thus, more wealth would be available to pass to future generations.

With opportunity often comes risk, and it's only fair to point out a risk inherent in Roth plans of any nature. Since Roth contributions are funded with after-tax dollars, it is possible to make an investment that subsequently loses most or all of its value ' yet all income tax will have already been paid and is lost as well. Say, for example, you contribute $15,000 to a traditional 401(k) account. If you are in the 40% tax bracket, you will save $6,000 in taxes, so that if the $15,000 investment is subsequently lost, your true net loss is only $9,000. Conversely, losing a $15,000 Roth-funded investment (made with after-tax dollars) would in fact cost you the full $15,000. It might be argued that riskier investments are better suited to a traditional 401(k) account, and more conservative investments should be directed to a Roth account.

Employer Costs and Benefits

There are certain costs specific to adding a Roth 401(k) option to an existing plan. First, the plan document must be amended by the administrator. Next, partners and employees must be educated about the features of the new option so that informed choices can be made by all. Lastly, there will be higher ongoing administrative costs since many participants will have multiple forms of salary withheld (for pretax and after-tax contributions), and multiple account balances to keep track of.

Incurring such costs may viewed as a savvy investment by a firm choosing to offer the Roth option, since enormous goodwill is promoted by presenting everyone, partners and employees alike, with a new opportunity to accumulate tax-free wealth over the course of a career.

Unfortunately it is possible, based on rules designed to prevent plans from discriminating in favor of highly compensated participants, that not everyone, especially partners, will be permitted to make the maximum contribution that would ordinarily be permitted. Presumably, however, the strong merits of the Roth option will attract firm-wide participation, which would serve to minimize the chances of having a problem with satisfying the antidiscrimination rules.

Contributing to a Roth 401(k) v. A Traditional 401(k)

Let us now consider a hypothetical example of how a Roth 401(k) might benefit an employee/partner. Assume a 40% income tax bracket and a contribution of $15,000 to a Roth 401(k) plan in 2006. Does it make sense to pay $6,000 tax today ($15,000 x 40%) to make a Roth contribution, as opposed to a traditional one? If one earns a modest 6% per year for 25 years, the investment will grow to about $67,000. An increase to 9% will yield $141,000 in 25 years. Would someone pay $6,000 today to have accumulated earnings of $126,000 ($141,000 – $15,000) be fully tax-free at retirement? Now, consider repeating this scenario annually rather than doing it just once, and the true potential of the Roth becomes clear.

The 25-year timeline demonstrates that in general, there is more “upside” potential for younger Roth participants, and more risk for older participants. The younger a participant is, the more years there are for investments to grow tax-free, the more time there is to recover from a poor investment, and the more opportunities there will be to contribute to the plan ' if the law is extended beyond 2010. Additional factors to consider include one's age, risk tolerance, cash needs, projected rates of return on investments, and income tax brackets both now and at retirement.

If the law firm chooses to add the Roth option to its 401(k) plan, partners and employees will want to plan carefully, to ensure that their decision will be an informed one, suited to their needs, expectations and specific situation.