Guest Article

How Valuable is the New Roth 401k Option?

By Herbert A. Whitehouse. Mr. Whitehouse is Chief Fiduciary Officer at The Bogdahn Group of Orlando, FL. He can be reached at 407.246.7221 or herbw AT bogdahnconsulting.com.

Congress limits both the Roth and the traditional 401k contribution to $15,000. At a $15,000 contribution level, the Roth provides a 1/3 higher tax shelter value for an employee who is taxed at a 33.33% rate both today and at the time of a future distribution from the 401k.

The Roth is even more valuable if there is a risk of higher taxes on distributions.

Some, but often not all, of this advantage may be lost for the individual whose marginal tax rate will be lower when his or her monies are distributed from the plan. Commentators have suggested that many plan sponsors will not add a Roth option to their 401k plan because their retirees will be taxed at a lower rate in retirement than during employment.

We suggest that this comment misses several core advantages to the Roth option. These advantages will be discussed in the remainder of this article. But it is worth emphasizing at the outset that the greater tax sheltering power of the Roth contribution means that the Roth can add value for an employee even when that employee expects to be taxed at a lower rate in the future.

Of course, many employees, including many young and lower paid employees, may reasonably expect that the tax rate on their distributions will not be lower than their marginal tax rate today. This expectation is very fact specific; and it will vary for every individual, even if Federal, State, and local income tax rates are expected to remain constant.

Moreover, just as it is prudent to diversify investments with assets of different risk and return characteristics, employees for whom the benefits of the Roth are uncertain may find it prudent to use the Roth option for a few years in order to diversify their tax risks.

It is also important to remember that each individual employee has significant control over plan withdrawals - more control under a Roth -- and each employee has information about his or own financial and tax situation to help make withdrawal decisions.

For some employees, having a Roth option is like being given the option to buy life insurance without a physical. For others, the definite advantages of the Roth will offset even the risks of lower tax rates at the time of future plan distributions.

How Does the Roth Work

For those new to this question, Roth 401k contributions are made after-tax, while both the contribution and the earnings on those contributions can be withdrawn tax free. This approach differs from the traditional 401k in which taxes on both contributions and earnings are deferred until withdrawal.

At a 33.3% tax rate, an employee contributing $10,000 to a Roth account will have paid $5,000 in tax on $15,000. Only the after-tax $10,000 is contributed into the Roth 401k account. However, when these monies are distributed five or more years later, there is no tax paid, even on any earnings or appreciation. In contrast, the employee contributing $15,000 by way of a salary reduction will pay no tax on the $15,000 contribution going in; but both the contribution and any earnings will be taxed when paid out.

These two arrangements, at these contribution levels, are intended to be equivalent when tax rates are the same on the contribution as on the distribution. We will talk about what happens with higher contribution levels later in this article.

Some commentators have suggested that the value of a Roth 401k option hinges on predicting a participant's future marginal ordinary income tax rate at the time of distribution. A few points should be made about this. First, decision making usually involves the evaluation and consideration of risk without making simplistic yes or no predictions. And secondly, there is certainly a risk that Federal, State, and/or local income tax rates will increase. But more importantly, while Congress may have designed the Roth 401k option to be the financial equivalent of a traditional 401k when tax rates are the same at time of distribution as at the time of contribution, there are several ways in which the Roth option provides a materially greater benefit to participants. One of these additional benefits, of course, is the effective raising of the §402(g) limit for the Roth. This and other Roth benefits exist on top of any advantage that may accrue to a participant who will have a higher tax rate on a plan distribution. These additional Roth benefits must be offset against any impact from lower distribution tax rates.

Calculating the Added Value of a Roth

If the maximum Roth contribution was 1/3 more valuable (more or less depending on the employee's marginal income tax rate) than the traditional 401k, almost every plan sponsor would add optional Roth accounts. But the value equation is more complicated than this. A $15,000 Roth contribution, still using our 33.3% marginal tax rate, is the equivalent of a $22,500 traditional contribution. But since contributions are limited to $15,000 ($20,000 with make up contributions for employees over age 50) a traditional 401k contribution provides the employee with $5,000 (the after-tax value of the $7,500 that $15,000 is less than $22,500) to invest outside the plan.

Because of this, a fair comparison of the Roth advantage must now look at the tax impacts of three kinds of investments -- Roth, traditional salary reduction, and investments outside the 401k plan. Still, a simple formula can be used to show the net Roth advantage at various tax rates.¹ While Sentinel has developed a model to help our clients look at the participant impact at any combination of current and distribution tax rates, the following formula calculates the Roth advantage at a constant tax rate. The formula also assumes that all non-plan gains are eligible for favorable long term capital gains tax treatment.

Understanding this formula requires understanding only one basic principle: After-tax Roth contributions at the $15,000 §402(g) limit must be compared to a combination of pre-tax and after-tax contributions worth $22,500.

Most employees can make the traditional pre-tax 401k approach the equivalent of a Roth after-tax contribution simply by contributing an appropriately greater amount pre-tax. This equivalence is more than mathematical, it is also practical. An employee contributing money pre-tax can make a higher contribution with the same impact on take home pay because no current income taxes are paid to the government on pre-tax contributions.

Benefit of Placing High Growth Investments in a Roth Account

A commonly asked question is this: "Isn't the fact that Roth investment growth is paid out tax free an advantage relative to the traditional 401k account?" This question is usually asked in the context of thoughts about asset allocation optimization.

The general idea is to put high potential growth investments, albeit those at the greatest risk, into the Roth account, while more conservative and lower return components of an individual's portfolio are put into a traditional 401k account. After all, the thinking goes: "If a $15,000 equity investment might grow to be worth a million dollars before I retire, shouldn't I put this investment into a Roth where all the growth can be paid out tax free? I can stay diversified by putting my more conservative fixed income investments into a traditional 401k account."

This hoped for asset allocation advantage is largely illusory, except for the important use of a Roth for eliminating distribution tax rate risk. Asset allocation generally can not be used to leverage the tax free aspect of the Roth account. The reason is intimately tied into the nature of the Roth account. Except at §402(g) limits, the tax sheltering power of an after-tax Roth can be matched in a traditional 401k just by contributing the real before-tax Roth amount into a pre-tax traditional account.

Accordingly, any advantage (except for managing the risk of changes to the distribution tax rate) to allocating high expected return investments to the tax free Roth account is offset because the taxable (pre-tax) traditional 401k account will generally be larger than the monies allocated through a Roth account.

Of course, the equilibrium point between traditional 401k and Roth 401k contributions is dynamic. It will change over an employee's career; and it will change based on other factors influencing expected distribution tax rates.

An employee may begin contributing to a 401k plan as a young employee when his or her marginal tax rate is 15% or 20%. At the time, there may a significant chance that the 401k account balance will be distributed in a lump sum on his changing jobs, or on buying a house -- long before retirement. Later, this same employee may be a high paid executive near retirement and with significant other executive deferred compensation as part of the picture.

Regardless, lets look at a simple hypothetical example of an attempt to gain an asset allocation arbitrage advantage. Assume that in 2008, an employee has $100,000 in his Roth account, and $150,000 in a traditional account. Now the question is whether it makes a difference where the Roth monies are invested.

The equity funds are expected to (and do in this hypothetical) increase in value by a multiple of 10 prior to withdrawal. The time period here really does not matter. The more conservative fixed income investments are expected to, and do, increase in value by a multiple of five.

In a situation where all Roth (after-tax) monies will be paid out tax free, and all traditional (pre-tax) monies are subject to a 33.3% tax on distribution, let's see if it makes any difference whether the Roth account or the traditional account is invested in equity.

Scenario One:

a) All after-tax Roth account monies are invested in equity.
b) All traditional salary reduction (pre-tax) 401k account monies are invested in fixed income.

The $100,000 in equity grows to $1,000,000; and because it is Roth money is paid out tax free. The $150,000 in fixed income grows to $750,000. Because the fixed income money is traditional pre-tax money, it is taxed on distribution.

The total net distribution for both accounts is $1,500,000.

Scenario Two:

a) All pre-tax traditional 401k account monies are invested in equity.
b) All Roth (after-tax) 401k account monies are invested in fixed income.

The $150,000 in equity grows to $1,500,000; but because it is not Roth money it is subject to tax. The net pay out is $1,000,000. The $100,000 in fixed income grows to $500,000. Because the fixed income money is Roth (after-tax) money, it is not taxed on distribution.

The total net distribution for both accounts is $1,500,000 - the same as in Scenario One.

When an advisor suggests a 50/50 asset allocation to an employee with both traditional (pre-tax) 401k and a Roth (after-tax) monies, what does this mean?² In the above scenarios, putting all of the traditional 401k account ($150,000) into equity provides a 50/50 equity allocation; and so does putting all of the Roth account ($100,000) into equity!

With this in mind, how does an employee go about deciding on an asset allocation? The key, as in most investment decisions, is the evaluation of risk. There are many possible paths for this employee's tax future - each path determining the tax that will be applicable to traditional 401k distributions. The best estimate is that the distribution will be taxed at a 33.3% rate. Let's assign a 50% probability to this outcome. To illustrate the decision process, lets simplify the other possible probability paths to only two. The first is for the rate to increase by 6.666% to 40%; and the second is to decrease by 6.666% to a 26.666% rate.

In our hypothetical, 33.3% is the equilibrium tax rate at which the $1,500,000 traditional 401k account is equal in value to the $1,000,000 Roth account. However, if distribution tax rates were to be 40%, the traditional account would drop in value from $1,000,000 to just $900,000.

Obviously, this is a substantial impact. The real world key to this asset allocation decision is to determine if the probability of a distribution tax at higher than the equilibrium rate is greater than the probability of a lower rate. This determination must also consider the likely size of the possible rate in each direction. For example, relative to the equilibrium rate of 33.3%, a 25% chance of a 40% distribution tax is equal to a 50% chance of a 30% distribution tax.³

Participants can reflect these risks in their asset allocation decisions. A more basic observation, however, needs to be made. An employee who wants to include distribution tax rate risk in his or her asset allocation decisions has no way to do so with only a traditional salary reduction account option -- a Roth option is required.

Does the Roth Have Any Value to Lower Paid Employees

As we saw in the prior section; one of the important advantages to the Roth is that it helps plan participants manage the distribution tax risk. Federal, State, and/or local tax rates may increase in the future; and employees who are currently at the lowest tax rates may experience higher marginal tax rates at the time of distribution. Employees who are currently taxed at the 33%⁴ marginal tax rate at the national level, have little of this latter risk. Only lower paid employees have this risk.

Theoretically speaking, low paid employees (especially those in dual income families) may also contribute at the 402(g) limit of $15,000, or $20,000 for employees over age 50. But the effective equivalence of a Roth at the 402(g) limit to a higher traditional salary reduction limit will not be a benefit to many lower paid employees. The added value of a Roth to lower paid employees, especially younger employees, is that it eliminates the risk that distribution tax rates will be higher than the employee's current marginal tax rate.

This risk is substantial in this period of historically low tax rates. As mentioned previously, it is also a significant risk for young employees who have decades to increase their education, experience and income. Moreover, many young and lower paid employees will withdraw their 401k in a lump sum when they change jobs. The tax on these distributions will often exceed their tax rate on ordinary pay.

Roth Value at the §402(g) Limit

At a 33.3% tax rate, the Roth provides a 1/3 greater tax shelter once a contribution is inside the 401k plan. In exchange, the participant making Roth contributions pays taxes up front. At the §402 (g) contribution limits, however, this equivalence breaks down. The employee contributes $15,000 to a Roth after-tax. At this tax rate the employee pays a $7,500 tax on $22,500, leaving $15,000 to contribute.

At lower contribution levels, say a $10,000 Roth, the employee could make an equivalent pre-tax 401k contribution of $15,000, saving the $5,000 difference in current taxes. But at the §402(g) limit, the rules prevent employees from matching the Roth tax shelter. At a $15,000 Roth contribution level the traditional pre-tax approach is also limited to $15,000. The other $7,500 cannot be contributed pre-tax; and so it is taxed (at our 33.3% rate in this hypothetical) and the remaining $5,000 is available for investment outside of the plan.

While the effect of the §402(g) limits is to make the Roth 401k tax shelter 1/3 larger than what Congress permitted for the traditional salary reduction 401k, the full comparison also needs to take into account the $5,000 (after-tax) because the employee only contributed 2/3 of $22,500 into the traditional pre-tax 401k. This analysis is fairly complicated, and the relative advantage of the Roth over the traditional 401k approach varies according to the asset allocation selected. Sentinel Fiduciary Services developed a stochastic simulation model to assist clients in understanding that the Roth not only provides a 5.26% higher return when all monies are invested in equity, but that the Roth provides an even more valuable benefit through allowing participants to establish an asset allocation suitable for their own risk tolerance without adverse tax consequences. (See below.)

But this model is also useful in quantifying a very basic aspect of the Roth; namely, the extra return that a Roth 401k provides participants who contribute at the §402(g) limit. For example, participants electing to invest in an equity fund could expect to achieve approximately a $1,000 advantage on average in just five years. Our model also illustrates the range of investment performance that might be expected based on the volatility of any investment fund. At 90th percentile performance⁵ over the same five years, the Roth advantage, in terms of net dollars available, would be nearly double. Obviously, longer term investments, and/or multiple year Roth contributions, can be worth many thousands of dollars to an executive.

Understanding Why the Roth Advantage Does Not Depend on Higher Distribution Tax Rates

Let's return to understanding why a financial advantage exists when employees maximize Roth contributions. The reason is simple. Congress set the same limit for both Roth and salary reduction contributions.

Under the Roth approach, an employee would pay $7,500 in taxes on $22,500 (at a 33.3% tax rate) in order to be able to contribute $15,000, net, to the Roth. Under a salary reduction approach, $15,000 of the same $22,500 is contributed without any initial tax. The remaining $7,500 is taxed at the same 33.3% tax rate, leaving $5,000 for the employee to invest outside of the 401k plan. This $5,000 can be invested in equity in order to obtain the advantage of long term capital gains tax rates.

The net impact of this is that the Roth is the more effective tax shelter for when contribution tax rates are the same as distribution tax rates.

Walking Through the Financial Advantage of a Single Roth Contribution using a "Twin Brother" Illustration

The Roth Advantage is the Greatest for Risk Adverse Employees

The Roth advantage illustrated up to this point has assumed identical equity investments for the Roth after-tax contribution, for the traditional (pre-tax) 401k contribution, and for the non-plan investment. However, if an employee's risk tolerance is such that equity is not an appropriate investment, the advantage to a Roth 401k option is increased substantially.

Fixed income investments are generally not eligible for long term capital gains tax treatment. Moreover, any interest or dividends will be subject to tax each year. A participant might be able to invest in tax free municipal bonds if the concentration in that asset class was appropriate; but he or she would generally have to accept lower returns in exchange for the more favorable tax treatment.

There are no tax obstacles to optimizing an asset allocation in a Roth. If a Roth option is available, a participant can diversify and design his or her asset allocation without adverse tax consequences This Roth advantage is at least as significant to a risk adverse participant as the Roth's greater tax sheltering power.

The Roth's Legacy Advantage

There is another advantage to the Roth 401k that should be mentioned -- its legacy value. A Roth IRA (and roll-overs from a Roth 401k to a Roth IRA) is not subject to the minimum distribution rules of a traditional 401k. This means that the Roth provides an opportunity to create an income tax free fund for the joint lives of the employee and his or her spouse. In addition, under a Roth IRA, naming a beneficiary (e.g., a child or grandchild) may avoid the need for a complete distribution within five years of the death of the investor or her surviving spouse. Moreover, by selecting a young beneficiary for a Roth IRA, employees can significantly extend the period of time that a Roth can grow tax free.

Conclusion

There is a certainty that, for at least some employees, taxes on 401k distributions will be higher than the marginal income tax rate on 401k contributions.

Providing employees with the flexibility to manage this distribution tax risk is an important advantage to a Roth 401k option.

Another advantage is that the Roth should improve plan communications with younger employees about 401k participation. Today, at a time of historically low tax rates, employees who are at the lowest of these historically low tax rates (some currently at 15% or 20% tax rates) are being told that tax deferral makes sense for them.

Especially now, when a Roth option can provide these young employees a way to save with significant tax advantages -- fundamentally equivalent to the traditional 401k if distribution tax rates are equal to contribution tax rates -- but without the risk of deferring income into higher tax rates, this traditional message may adversely impact the credibility of all plan communications.

And, of course, for some employees the Roth offers the equivalent of an increase in the §402 (g) contribution limit.

ENDNOTES

1. The formula illustrates another risk for employees considering the traditional salary reduction approach; namely, the risk of higher future long term capital gains tax rates. Commentators who have discounted the risk of higher ordinary income tax rates have generally not discussed the combined risks of: a) higher ordinary income tax rates, b) higher long term capital gains tax rates, or c) an increase in both rates.
2. Assume for this example, that there is no home equity and no outside-the-plan investment.
3. This observation is much more significant than it may seem. Many commentators cite likely lower tax rates on distribution as a reason for not offering a Roth option. However, when the tax rate differential is small, it will not offset the large §402(g) advantage that exists simply because of the effectively higher limit on Roth contributions than for traditional salary deferral contributions.
4. This article uses a combined 33.3% Federal, State, and local tax rate in order to more easily portray relationships between pre-tax and after-tax contributions.
5. Meaning that only 10% of the simulations in our model had higher investment returns.

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