The Numbers Don’t Lie

I’ve had several advisors ask me to create a newsletter on Roth 401(k) plans and I was not motivated to issue one until I spoke at and attended a seminar on Monday in Orange County California for NAIFA and the SFSP.  At this seminar I finally saw first hand Doug Andrews speak on the topic of equity harvesting.  Doug wrote the cult like book called Missed Fortune 101.

If you’ve read any of my newsletters over the last year you would have seen a few titled “What’s wrong with Missed Fortune 101” (parts 1 and 2).   I don’t want to re-debate the pros and cons of Doug’s book, but what motivated me to write this e-mail is Doug’s dismissive attitude towards the benefits of either a Roth IRA or Roth 401(k).  Many advisors follow religiously the teaching in Missed Fortune 101 and I wanted to dispel one of the faults with the book (the fault where he tells readers NOT to fund qualified plans above the employer match and instead fund life insurance as a “retirement” tool) by discussing the benefits of a Roth 401(k).

The New Roth 401(k) Plan

A new retirement account was signed into law on August 17, 2006. It is a component of a “regular” 401(k) plan; however, the funding of a “Roth” 401(k) plan is funded with AFTER-TAX dollars. This is similar to the Roth IRA but with higher funding limits and no limit on earnings to contribute. Money contributed to a Roth 401(k) plan grows without tax and is distributed without tax. (In 2007, the funding limit is $15,500 ($20,500 if over the age of 50)).

Who should use a Roth 401(k) Plan?

-Anyone who will be retiring with the same or higher tax-bracket.

-Anyone who will be retiring with a tax-bracket within 10% of their current tax-bracket.

For example, if your clients are in the 40% tax bracket and retire in the 30% tax bracket, using a Roth 401(k) is still a better financial tool. An example is really the best way to crystallize the benefits of a Roth 401(k) plan and when it is appropriate to use one.

For this example, assume the client (age 40) contributes $15,000 to a Roth 401(k) plan each year for 25 years and takes distributions from the plan from age 66-85.

Because the contribution is non-deductible to the plan, the client will have to pay the following taxes on his/her contribution:

-40% tax bracket = $6,000 tax

-30% tax bracket = $4,500 tax

-15% tax bracket = $2,250 tax

Assume a 7% investment returns over the life of plan.

For a comparison example, the client will invest an amount of money equal to the taxes he/she would have saved in taxes had a “regular” non-Roth 401(k) been implemented (a side account).

-$6,000 for the client in the 40% tax bracket

-$4,500 for the client in the 30% tax bracket

-$2,250 for the client in the 15% tax bracket

When clients actively invest money in the stock market after tax, in order to have a real world example, the numbers must reflect a capital gains/dividend taxes on the post-tax brokerage.  The following are the assumed annual taxes on the growth in the account.

-25% for the client in the 40% tax bracket

-20% for the client in the 30% tax bracket

-15% for the client in the 15% tax bracket

How much can this client receive in retirement from him Roth 401(k) plan?

$60,831 from the plan income-tax free every year for 20 years (66-85).

If the client instead funded a regular taxable 401(k) the following is how much the client could receive from ages 66-85 after-tax?

-$36,498 in the 40% tax bracket

-$42,581 in the 30% tax bracket

-$51,706 in the 15% tax bracket

The above numbers must be added to the side account the client would have funded with the extra dollars he would have had from funding a deductible 401(k) plan.  From the side account, the client could receive the following amounts after tax from ages 66-85.

-$18,063 in the 40% tax bracket

-$14,510 in the 30% tax bracket

-$7,769 in the 15% tax bracket

Totaling the numbers:

From a regular 401(k) plus side account after-tax the client would receive the following from ages 66-85:

-$54,562 in the 40% tax bracket

-$57.092 in the 30% tax bracket

-$59,475 in the 15% tax bracket

Who wins?  Since the client could receive $60,831 from a Roth each year, the client who funds a Roth 401(k) wins.

Manipulating the numbers

What if the same client starts in 40% income-tax bracket and then drops down to 30% in retirement?  He/she could take out $60,645 over the same time period.

What if 30% and then 15%? $66,216.78

What if 30% and then up to 40%? $51,008

What if 40% and then 15%? $69,770

Summary

Simply put, Roth 401(k) plans are financially beneficial for nearly every client.  If that is the case, and if few clients have such plans, that means there is a world of opportunity out there and therefore, you can use this topic to help current clients and gather new clients.  What you should also learn from this newsletter is that if you have a traditional 401(k) plan in your business, you should consider offering a Roth 401(k) plan so you can take advantage of the benefits yourself.

Spreadsheets

I had numerous requests at the seminar I spoke at this week to e-mail out a link so advisors could review the numbers which determine if investing in life insurance post-tax is better than funding a tax-deferred a qualified plan.  The answer is NO and if you would like to review six spreadsheets I created, you can do so by clicking here.

Copyright 2006, The Wealth Preservation Institute.