Estate Planner September-October 2006
Beginning this year, businesses can establish a Roth 401(k) plan or add a Roth contribution option to an existing 401(k) plan. Yes, these plans offer attractive retirement benefits, but the estate planning benefits may be their biggest draw. You must, however, bear in mind that the Roth 401(k) plan provisions expire at the end of 2010 unless Congress acts to extend them.
Tax-free retirement income benefits
Like a Roth IRA, contributions to a Roth 401(k) aren’t tax deductible, but earnings accumulate tax-free and can be withdrawn tax-free in retirement. This can be a big advantage, particularly if you expect your income tax bracket to increase after you retire.
High income taxpayers, however, haven’t been able to take advantage of the Roth IRA. (Under the Tax Increase Prevention and Reconciliation Act of 2005, beginning in 2010 there will no longer be any income limitation on converting a traditional IRA to a Roth IRA.) Eligibility for contributing to a Roth IRA is phased out beginning at $95,000 of modified adjusted gross income (AGI) – $150,000 AGI for joint filers. The Roth 401(k) provides you an opportunity to enjoy the Roth benefits, because there are no AGI limits for contributing.
Contribution limits for Roth 401(k) plans are the same as for traditional 401(k) plans: In 2006, the maximum contribution to all 401(k) accounts is $15,000, plus a $5,000 “catch-up” contribution if you’re 50 or older by the end of the year. If no AGI phaseout applies, Roth IRA contributions are limited to $4,000 plus a $1,000 catch-up contribution.
Stretch out estate planning benefits
It’s often said that traditional IRA and 401(k) accounts are the worst assets to leave to your heirs. Why? Because the combination of income and estate taxes can shrink these accounts to a fraction of their original value. But Roth accounts don’t have this drawback because qualified distributions aren’t subject to income taxes.
With careful planning, assets in a Roth 401(k) account can continue growing tax-free throughout your lifetime and beyond – provided you have other sources of retirement income. Although a Roth 401(k), like a traditional 401(k), is required to begin mandatory distributions when you reach age 70 1/2, IRS rules allow you to roll the funds over into a Roth IRA, which isn’t subject to mandatory distribution requirements until the death of the Roth owner.
This technique allows you to stretch out the account’s tax-free benefits, providing a valuable nest egg for your children and even your grandchildren. Heirs are required to take distributions, but the distributions can be spread out over their lifetimes. Depending on the size and growth rate of the account, this means there may even be more left in the account for the grandchildren’s benefit.
Too good to last?
If Congress doesn’t act to extend the Roth 401(k) provisions, you’ll have to stop contributing to the account after 2010. But you should be able to leave your previous contributions in the account or roll them over into a Roth IRA.
If you feel a Roth 401(k) is right for you, and your employer offers it, at the very least you’ll have a little over four years to take advantage of its retirement and estate planning benefits.