Following the recent passage of legislation to avert the “fiscal cliff,” it is evident there is much work ahead for the country to get its financial house in order.
While much discussion has centered on taxes and spending cuts, another significant issue is the country’s aging population and financial state of Social Security. With Social Security financed by Treasury IOUs and having no actual cash set aside, the program’s surpluses are expected to turn into deficits—and could be a further drag on the economy and add to the nation’s debt.
Eventually, there will likely be changes to Social Security and Medicare—such as the 3.8% Medicare tax that kicked in this year for high-earning Americans.
In the wake of uncertainty, the best course of action is to save more for retirement. The only way to accomplish this is to revisit spending and priorities. Keeping an automobile longer, looking to colleges with lower tuition and cutting back on discretionary spending are just a few examples of freeing up dollars to save toward retirement.
Some government policymakers understand there need to be incentives to help the public save for retirement. Buried in the fiscal cliff legislation is an intriguing provision that allows participants of 401(k) plans with a Roth 401(k) feature to convert their regular before-tax 401(k) balances, pay the taxes and have the funds rolled into a Roth 401(k) account.
Roth 401(k) accounts can be withdrawn income tax-free in retirement and are not subject to the minimum required distribution (MRD) limits that regular 401(k)s and IRAs are subject to when the account holder turns age 70 ½ (and is no longer working if he is in a 401(k) plan and does not have ownership in an agency).
This can be a valuable option for employees who are in lower income tax brackets, or for people who want to convert some of their pre-tax 401(k) plan balances and are able to pay the regular income tax on the amount they rollover. The amount converted from the pre-tax 401(k) plan balance to the Roth 401(k) plan account is not subject to the 10% excise tax at the time of the conversion.
It is important to note that the 401(k) plan must have a Roth 401(k) feature in order to take advantage of the provision. Currently, less than half of all 401(k) plans have a Roth feature, and many plan sponsors are unaware that it’s even a possibility. And, if a plan sponsor wants to add a Roth feature to their 401(k) plan, the challenge will be to get the plan participants to understand the trade-off of paying taxes on their contributions first and having them grow tax-free through the Roth 401(k) feature.
Typically, the profile of an employee who should consider a Roth feature—either contributing after-tax or converting their pre-tax 401(k) plan balance—is someone whose tax bracket will be higher in retirement than their current tax bracket. Another candidate might be an older employee who has other assets and wants to convert a portion of their 401(k) plan balance from before–tax to after-tax.
It’s important to remember that Medicare Part B premiums are “means tested”—the higher a person’s income is in retirement, the higher his Part B premiums will be. So the analysis needs to take in other considerations.
The bottom line? In order for employers and employees to take advantage of this provision, they will need advice themselves, as well as for their employees. This creates an opportunity for independent agents to help their clients assess whether a Roth 401(k) feature makes sense for their organization.
Dave Evans is a certified financial planner and an IA l-h contributing editor.