Staring in January, small business owners can line up to collect a gift from Uncle Sam. It's the Roth 401(k) and, according to financial advisors, it may be the best deal available for business owners who want to save on taxes in retirement and/or find ways to pass on wealth tax-free to heirs.
Indeed, some retirement-planning professionals think that the new Roth 401(k) is too good to be true — and are predicting that Congress will take it back. Like the earlier Roth IRA, the new Roth 401(k) allows an investor to accumulate tax-free returns and permits tax-free withdrawals. The big difference is that, unlike the individual Roth 401(k), the company sponsored Roth 401(k) does not have strict income limits ($95,000 for an individual and $150,000 for a couple), observes Barry Milberg, president of ERISA Expertise, a pension advisor and third-party administrator in Blue Bell, Pa., which recently launched a new business, roth401kinfo.com. Milberg figures that the new plans are such a good deal that they will not be renewed after their scheduled “sunset” in 2010.
Originally enacted as part of the 2001 tax-cut package, the Roth 401(k) was stalled by rule making that was completed only in the final weeks of 2005. Now that the final rules are established, says Milberg, business owners should pounce.
First, the retirement angle: like the earlier Roth IRA — and unlike non-Roth retirement plans, such as SEPs and IRAs — Roth 401(k)s use after-tax dollars. Owners experience pain upfront, but earnings grow tax-free. However, unlike traditional IRAs and 401(k)s, distributions are not taxed. So, owners avoid the situation that many retirees now face, which is seeing their retirement incomes taxed just like their preretirement wages. (The conventional financial-planning wisdom has held that people can afford the tax hit when they withdraw money from retirement accounts because their post-employment income will drop them into a lower tax bracket. Increasingly, retirees — especially high earners — have found that this is not the case: They need nearly as much income to sustain their lifestyles in retirement).
Milberg's calculator can be used to test various scenarios. The overall concept is to use the Roth savings alongside taxable distributions to create a blended cash flow that reduces effective income tax rates. If a business owner already sponsors a 401(k), he can add a Roth option so that he and his employees can choose pretax and post-tax contributions or divide contributions (up to the annual limit of $15,000 this year, plus $5,000 “catch-up” contributions for those over 50) between the two types of accounts.
Perhaps the biggest benefit for business owners, however, may be in estate planning. “A Roth is clearly the best asset to leave a beneficiary,” says Christopher Lauch, vice president of retirement and annuity marketing for Pioneer Investments. Like other investment management companies and insurers, Pioneer in January began offering Roth 401(k)s, including solo versions for sole proprietors.
The estate-planning angle is a bit complicated and should be done in consultation with an advisor, but here are the basics: Like a traditional 401(k), a Roth 401(k) account is subject to distribution requirements — owners have to start taking out money at age 70 1¼2. But a Roth IRA does not have this requirement and the rules permit participants to roll a Roth 401(k) into a Roth IRA without penalty. So, a business owner can roll the funds from a Roth 401(k) into a Roth IRA and let the money accumulate tax-free during his lifetime and beyond. The owner can even name a grandchild as the beneficiary, providing a nest egg that can continue to grow throughout the child's lifetime. Of course, the owner has to be in a position to live without that money in retirement. But if he has already adequately funded a retirement account, this may be an option.
Again, the Roth 401(k) can be such a good deal for a business owner that retirement experts don't expect it to last. “We're looking at this like you have five years to take advantage of it,” says Lauch. In the meantime, he adds, the big hurdle may be convincing your accountant, who is programmed to fund retirement savings with pretax money, that this is a good deal. According to Pioneer, when you factor in the benefits of tax-free distributions, under most scenarios the Roth comes out ahead.
— This article first appeared in the Small Business Review, a new e-letter from the publisher of Trusts & Estates.
To learn more about this e-publication, visit smallbusinessreview.com.