401(k) wars: revenge of the Roth

Tax-qualified 401(k) plans were first permitted to allow Roth 401(k) contributions effective January 1, 2006. A Roth 401(k) contribution is similar to a traditional 401(k) contribution, except that the Roth 401(k) contribution is made on an after-tax basis.

Traditional pre-tax 401(k) contributions and after-tax Roth 401(k) contributions are subject to a single limit which applies to both types of contributions. For 2006, the 401(k) contribution limit is $15,000 (or $20,000 for an employee who has reached age 50, assuming that the plan permits “catch-up” contributions). An employee can elect to split 401(k) contributions in any manner the employee desires. For example, a 50 year old employee electing $20,000 in 401(k) contributions for 2006 could designate all $20,000 as traditional pre-tax contributions, all $20,000 as after-tax Roth contributions, or $10,000 of each type.

Unlike Roth IRA contributions (which first became available in 1998), Roth 401(k) contributions are not restricted to individuals with adjusted gross income above any particular level. Therefore, any physician can elect Roth 401(k) contributions, as long as Roth contributions are permitted under the plan in which the physician participates.

Distributions from Roth 401(k) accounts (including investment gains on Roth contributions) are completely tax-free, provided that the distributions are made (a) not less than five years after the Roth 401(k) account was started, and (b) after the employee has reached age 59 1/2, died or become disabled.

Although the law permitted Roth 401(k) contributions effective January 1, 2006, employers who sought to add the Roth 401(k) feature to their plans at the beginning of the year encountered several significant impediments. First, IRS regulations addressing the technical rules governing maintenance and taxation of Roth 401(k) accounts were promised by the IRS but not yet published. Second, pointing to the lack of regulatory guidance from the IRS, the majority of mutual fund companies and other 401(k) plan recordkeepers did not have their systems ready to accept and track Roth 401(k) contributions as a separate source subject to different tax treatment. Finally, interested employers were precluded from adopting plan amendments required to implement 401(k) provisions because model plan language promised by the IRS had not yet been published.

All of the impediments to Roth 401(k) implementation have since been removed. First, the IRS issued two fairly comprehensive regulation packages in January of 2006. As with most regulations, the IRS guidance did not answer every possible question concerning accounting for and taxation of Roth 401(k) contributions, but the guidance is sufficient to allow operation of Roth 401(k) provisions. Second, almost all 401(k) recordkeepers have announced the availability of systems accommodating Roth 401(k) contributions, at varying dates during 2006. Finally, in April of 2006, the IRS published model language allowing lawyers and other plan document providers to prepare Roth 401(k) amendments satisfying IRS requirements.

A fourth factor which caused many employers to hesitate to add Roth 401(k) provisions was the fact that the tax law authorizing Roth 401(k) contributions was due to expire by its terms at the end of 2010. Interestingly, this factor was actually touted by proponents as well as opponents of Roth 401(k) contributions. Opponents suggested that a Roth 401(k) feature was not worth the trouble since it might only be available for a few years, while proponents suggested that employees should “get it while they can.” In any event, the Pension Protection Act of 2006 (enacted in August) made the law authorizing Roth 401(k) contributions permanent.

With all of the impediments removed and the law authorizing Roth 401(k) made permanent, interested physicians should feel free to implement Roth 401(k) provisions at any time (with the assistance of their third-party plan administrators and lawyers). But the removal of the impediments and the extension of the law does not answer the most difficult question: Do Roth 401(k) contributions make sense, i.e., are they better than traditional pre-tax 401(k) contributions?

Even the experts in the 401(k) industry cannot agree. Some say that Roth 401(k) contributions are the best thing since sliced bread, while others claim that retirement savings will ultimately be maximized with traditional pre-tax savings. The somewhat obvious rule of thumb is that Roth 401(k) contributions are better if the tax rate at the time of withdrawal is going to be higher than the tax rate at the time of contribution, and traditional pre-tax 401(k) contributions are better if the tax rate at the time of contribution is going to be higher than the tax rate at the time of withdrawal. If the tax rate remains constant, the same end result will be obtained,

Application of the rule of thumb does not end the analysis because it fails to address another very important question: If Roth 401(k) contributions are going to be elected (such that tax is paid up front), what money is going to be used to pay the tax? There are only three possible answers to this question. First, the 401(k) contribution can be reduced. For example, in lieu of a traditional 401(k) contribution of $20,000, a physician might elect to make a Roth 401(k) contribution of $15,000, with the other $5,000 (approximately) being paid as tax. Again, if tax rate remains constant, the end result is the same.

Second, the tax can be paid with money that would otherwise be saved by the physician outside of the plan. For example, if a physician has $50,000 to devote to 401(k) savings and savings outside of the 401(k) plan, he or she might contribute $20,000 in the form of a Roth 401(k) contribution, pay $7,000 (approximately) in tax, and save $23,000 outside of the plan (as opposed to making a traditional 401(k) contribution of $20,000 with no current tax, and saving $30,000 outside of the plan.) This analysis leads to questions involving the investment vehicles available in tax-deferred accounts versus those available in taxable accounts, but in most cases, if the tax rate remains constant, the ultimate savings will most likely be a bit higher under the Roth scenario.

Third, the tax on Roth 401(k) contributions can be paid with money that would otherwise be spent by the physician during the year. Under this scenario (i.e., if the Roth 401(k) feature is used as a “forced savings plan”), the ultimate savings will be significantly higher under the Roth scenario.

Taking all of the above into account, physicians who should consider Roth 401(k) contributions are those who fall into any one or more of the following categories:

Physicians who wish to absolutely maximize qualified retirement plan savings. Proponents of Roth 401(k) contributions suggest that a Roth 401(k) contribution of $20,000 is the equivalent of a pre-tax contribution of $27,000 or more since the tax on the Roth 401(k) contribution is being paid up front. Physicians who want to maximize qualified plan savings to the maximum extent possible should consider the Roth 401(k) option for this reason.

Physicians who expect their tax rate to be higher at the time of withdrawal. The initial reaction of most people is to reject Roth 401(k) opportunities because they assume their income will be lower in their retirement years and therefore they will be in a lower tax bracket. However, many experts observe that current tax rates are relatively low from a historical perspective, and suggest that this is likely to change. It is possible that a physician might be in a lower tax bracket during retirement years, but actually subject to a higher tax rate. Physicians should also be mindful of tax deductions (e.g., mortgage interest) that will no longer be available in retirement years.

Physicians who wish to diversify future tax risk. Investment advisors always preach the importance of diversification of plan investments among asset classes with different risk and return characteristics. Why not follow the same philosophy with regard to the tax character of retirement savings? Since future tax rates are not certain, diversification between taxable and tax-free accounts preserves maximum flexibility.

Physicians who expect to pass retirement plan savings to heirs. Traditional pre-tax accounts (including traditional IRAs as well as qualified plans) are subject to rules requiring certain minimum distributions beginning at age 70 1/2. However, Roth 401(k) accounts can eventually be rolled into Roth IRAs, and Roth IRAs are not subject to any lifetime minimum distribution requirements. Therefore, Roth 401(k) contributions ultimately allow a physician to pass larger tax-free accounts to heirs.

As suggested above, the ability to make Roth 401(k) contributions is only available under plans specifically permitting this type of contribution. Before a physician who is an owner in a practice can make a personal decision as to whether Roth 401(k) contributions make sense for him or her, the physician (together with others with decision-making power in the practice) must decide whether Roth 401(k) contributions should be accepted by the practice’s 401(k) plan. Some practices forego the Roth 401(k) opportunity simply because they do not wish to complicate payroll procedures, plan administration and employee education. However, these complications are manageable with proper professional guidance, and should not preclude interested physicians from pursuing Roth 401(k) opportunities. In any event, given the recent Pension Protection Act, physicians can rest assured that Roth 401(k) contributions will remain available under applicable law, at least for the foreseeable future.

Gary J. Gunnett, Esq., is a director in the law firm of Houston Harbaugh, P.C., in Pittsburgh, Pa.