A New Era in Retirement Planning
The Roth 401(k) is a very sharp tool, especially for business-owning clients
By Christopher G. Laucks
From the November 2005 Issue of Investment Advisor Magazine
There were more than 400 new tax rules in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and most went into effect years ago. But the time is finally arriving for one provision that will substantially alter the retirement plan market. It’s the Roth 401(k), and after a sustained period in which Americans have accumulated trillions of dollars in retirement assets through traditional 401(k) plans that will inevitably be taxed, the Roth option, which will be available January 1, 2006, opens the door to tax-free retirement income.
While the Roth 401(k) will hold appeal for millions of investors, perhaps no group will be more interested than high-income earners and proprietors of owner-only businesses. In addition to tax-free retirement income, it’s a highly effective estate planning tool, potentially helping to stretch assets and minimize taxes for decades.
The Roth 401(k) is similar to the Roth IRA in that it allows after-tax contributions to fund tax-free retirement income. However, the new Roth 401(k) rules allow for sharply higher annual contribution amounts than the Roth IRA—up to $20,000 in the 2006 tax year versus just $5,000 for the Roth IRA. Moreover, unlike the Roth IRA there are no income limits on investors who want to make Roth 401(k) contributions. Under current regulations, Roth contributions can be made to a new or existing 401(k) account, either as a substitute for or complement to pre-tax contributions.
Why might advisors look closely at this valuable new opportunity for proprietors of owner-only businesses? Simply put, the combination of high contribution limits and tax-free income could shift the balance in their effort to successfully prepare for retirement. Of the more than 65% of business owners who say the business is their primary source of income, nearly one third are over age 55. According to the Small Business Administration, small business owners are among those most likely to overlook retirement planning, in many cases resting their hopes on the sale of their businesses to fund their long-term financial needs.
Thanks to earlier provisions of EGTRRA, proprietors of owner-only businesses have had the option of establishing an owner-only 401(k) plan since 2002. These plans offer a potentially attractive alternative to traditional sole proprietor plans, particularly for business owners who can afford to set aside large amounts of money for retirement.
Operating like a large corporate 401(k) plan—but with lower costs and fewer administrative requirements—an owner-only 401(k) plan allows the business owner as “employee” to defer up to $15,000 of earned income in 2006. Individuals age 50 or older can make another $5,000 in so-called catch-up contributions.
In addition, the “employer” can make tax-deductible contributions of up to 25% of the employee’s earned income. In total, employer and employee annual contributions can reach as high as $47,000 or 100% of earned income. Contributions are not required in any given year, and unlike with SEP-IRAs, business owners may take tax- and penalty-free loans from the account — the lesser of $50,000 or 50% of their account balance.
Beginning January 1, 2006, EGTRRA’s Roth 401(k) provision allows business owners to direct either a portion or all of their employee deferrals to an account established to provide tax-free income in retirement. The difference with these contributions is that they will be made in after-tax rather than pre-tax dollars. Roth contributions are irrevocable; once they are allocated to a Roth 401(k) account, they cannot be shifted to a pre-tax account. The tax-deductible employer contributions will continue to be made to the pre-tax account.
“Qualified”—i.e., tax-free—distributions will be allowed only in the cases of death, disability, or attainment of age 59 1⁄2 as long as it has been at least five years since the initial Roth 401(k) contribution was made. Finally, Roth 401(k) accounts can be rolled into other Roth 401(k)s or Roth IRAs.
