Whenever I talk with 401k plan sponsors or participants about making Roth 401k contributions, at least half of them tell me they would never do it. They all cite the same reason. They don’t trust the federal government to keep its Roth 401k promise to allow tax-free distribution of Roth balances.
I think they are wrong — not about trusting Uncle Sam, but about whether the government will keep its Roth 401k promise.
Roth 401k Contributions
Everyone Should Make Roth Contributions
In an uncertain world, I believe the prospect of receiving all or a portion of your 401k balance tax-free at retirement is too good for any of us to pass up. The mechanics behind the Roth promise are making after-tax Roth 401k contributions, allowing the balances to stay in the plan for at least five years and withdrawing balances at retirement (not sooner). If these criteria are met, the entire balance in a Roth 401k account (including earnings) will be distributed tax-free.
Many advisors feel that determining whether a participant should make Roth 401k contributions requires an analysis of their current and future expected tax rates. Since the future is unknowable, I believe participants should hedge their bets by contributing something into their Roth 401k accounts. Anything, to at least get their Roth five-year clock started. Once the five year period is met (with as little as a $1 of Roth 401k contributions) any future contributions are immediately eligible for tax-free treatment. There is not a separate five-year clock for every Roth 401k contribution made.
Especially Your Executives
Because of their more complex tax situations, your executives may be very interested in making Roth 401k contributions as well as taking advantage of Roth in-plan conversions. Working with their tax advisors, executives should consider each year converting a portion of their existing pre-tax balances into after-tax Roth balances. During times when the equity markets are low, this strategy becomes even more appealing since it lowers the amount of taxes that an executive would pay while not forcing an executive to actually sell anything. A designated portion of a pre-tax account balance is re-characterized to Roth after-tax while leaving the number of mutual fund shares owned unaffected. So if markets are down 20%, an executive’s tax bill could be lowered by 20% as well.
Why You Should Believe The Roth 401k Promise
Michael Kitces recently wrote a great blog piece about why he thinks the Roth 401k promise will stick. And he is very convincing. He believes that one of the biggest reasons the federal government will keep their Roth 401k promise is because unwinding it and taxing balances does not produce enough tax revenue. All revenue raising proposals are now scored by Congress on their ability to produce revenue. Taxing Roth balances just doesn’t score highly enough. The second major reason that Congress won’t go back on its promise, according to Kitces, is that breaking it impacts older folks and retirees to a great extent. And older folks vote!
What You Should Do
Make sure that you add Roth 401k capability to your plan if you don’t already have it. It should cost less than $1,000 to amend your plan and communicate the Roth 401k feature. Talk about Roth 401k contributions and in-plan conversions in your employee education sessions. Your employees need to hear more about these benefits.
Robert C. Lawton, AIF, CRPS is the founder and President of Lawton Retirement Plan Consultants, LLC. Mr. Lawton has over 30 years of retirement plan consulting and administration experience and has provided consulting services to many Fortune 500 companies including: Aon Hewitt, Apple Inc., AT&T, First Interstate Bank, Florida Power & Light, General Dynamics, Houghton Mifflin Harcourt, IBM, John Deere, Mazda Motor Car Company, Northwestern Mutual, Northern Trust Company, Trek Bikes, Tribune Company, Underwriters Labs and many others. Mr. Lawton may be contacted at (414) 828-4015 or firstname.lastname@example.org.
Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to 401(k) plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or email@example.com or visit the firm’s website at: https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.