Whenever I talk with 401(k) plan sponsors or participants about making Roth 401(k) 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 promise to allow tax-free distribution of Roth balances. I think they are wrong – not about trusting Uncle Sam, but about whether Roth balances will be taxed.
In an uncertain world, I believe the prospect of receiving all or a portion of your 401(k) 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 401(k) 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 401(k) account (including earnings) will be distributed tax-free.
Many advisers feel that determining whether a participant should make Roth 401(k) 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 401(k) 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 401(k) contributions) any future contributions are immediately eligible for tax-free treatment. There is not a separate five-year clock for every Roth 401(k) contribution made.
Because of their more complex tax situations, your executives may be very interested in making Roth 401(k) contributions as well as taking advantage of Roth in-plan conversions. Working with their tax advisers, 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.
Michael Kitces recently wrote a great blog piece about why he thinks the Roth promise will stick. And he is very convincing. He believes that one of the biggest reasons the federal government will keep their Roth 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!
Make sure that you add Roth 401(k) 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 401(k) feature. Talk about Roth 401(k) contributions and in-plan conversions in your employee education sessions. Your employees need to hear more about these benefits.
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