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					THE ROTH 401(k): TO DO, OR NOT TO DO: THAT IS THE QUESTION!
Beginning January 1, 2006, Employer-sponsored retirement plans, at the Employer’s option, can permit participants to designate some or all of their 401(k) deferrals as a “Roth 401(k)” contribution. The advantage of a Roth 401(k) is that under current tax law, all qualified distributions are tax- free. The disadvantage is that contributions to a Roth 401(k) are with post-tax dollars (unlike traditional 401(k) contributions which are made with tax-deductible dollars). Is the loss of the tax deduction for a contribution to the Roth 401(k) worth the tax-free distribution of a qualified withdrawal? Whereas the answer to this question can be “Yes” for some investors, almost all investors will find it difficult to answer the question. The Roth 401(k) does have the potential benefits of increasing the after tax value of your retirement savings, creating some flexibility in determining the amount of taxable income you might receive in any give year during retirement , and leaving a valuable asset to your non-spouse estate beneficiary. Earnings on the distribution from a Roth 401(k) will be tax- free if the distribution is “qualified.” A qualified distribution must be paid after age 59½ or upon death or disability AND in all cases may not be paid during the five years following the first Roth 401(k) contribution to the plan or to a predecessor Roth 401(k) plan. Unlike a Roth IRA, distributions of Roth 401(k) contributions for a first time home purchase will not be a qualified distribution.

The advantages of the Roth 401(k) are limited to only certain plan participants. In general, the following investors should consider the Roth 401(k): 1. Low- and middle- income participants who are currently paying a low federal tax rate but who expect that their incomes will rise later on in their careers; 2. High income earners who are maximizing their 401(k) deferrals and would like to save more; 3. Participants who intend to leave an inheritance to a non-spouse, non-charity beneficiary; and 4. High income earners who cannot maximize their 401(k) deferrals due to failures in the Average Deferral Percentage Test. In general, the following investors should not consider the Roth 401(k) in place of a deductible deferral: 1. Participants who are expecting to rely principally on Social Security income for their retirement income; 2. Participants who expect to pay income taxes at the same or a lower rate during retirement than they are currently paying; 3. Participants who would defer less to make a Roth contribution (in order to pay the resulting taxes) and who would lose Employer matching dollars, if any; and 4. Participants with low incomes who might lose tax credits due to higher Adjusted Gross Incomes. There are exceptions to every rule. For you to make an informed decision about participating in the Roth 401(k) feature of your plan, you must invest some amount of time and effort in evaluating the pros and cons. In addition, you may find it necessary to consult with your financial advisor or CPA. Making better investment choices will have a bigger impact on the accumulation possible within your retirement account than whether or not to make a Roth 401(k) contribution. As important as it is to make an

informed decision about a Roth 401(k) vs. a traditional 401(k) contribution, reviewing the investment strategy within your portfolio will prove to be more productive. The Roth 401(k) provides an opportunity for you to prepay the taxes associated with the contributions and their earnings. There is no escape from paying taxes. Your option is to determine the timing of the payment. The General Rule: If the rate at which you would pay taxes on your Roth 401(k) contribution in the current year is the same rate at which you would pay taxes on traditional 401(k) withdrawals in the future, the after-tax value of a traditional 401(k) distribution is equal to the Roth 401(k) distribution. • If the applicable tax rate for traditional 401(k) withdrawals will be higher than the rate at which Roth contributions would be taxed when deposited, there is a monetary advantage for making the Roth contributions. • If the applicable tax rate for traditional 401(k) withdrawals will be lower than the rate at which Roth contributions would be taxed when deposited, there is a monetary advantage for making the traditional 401(k) contributions. The obvious difficulty in applying The General Rule is to know your future tax rate. It is not enough to know how much income you will be receiving at retirement; you need to forecast the changes which might be implemented within the tax code and estimate your future tax rate. It’s anybody’s guess the direction of future tax rates (and the purpose of this article is not for the author to make such speculations.) And the possibility exists that Congress, at some future date, might even legislate that Roth distributions are subject to taxation. Whereas most discussions on the wisdom of making Roth 401(k) distributions focus on the calculation of a future tax rate, do not underestimate the importance or difficulty of calculating your current tax rate. What Is the Tax Cost for Making a Roth Contribution? 1. Because Roth 401(k) contributions are not tax deductible, making a Roth 401(k) contribution will increase the amount of Taxable Income you will report in the current tax year. 2. Make a traditional 401(k) contribution and your Adjusted Gross Income will be lower. While these two statements are obvious, the impact of a Roth contribution on your effective tax rate is not quite so readily apparent. There is a big difference between your Taxable Income and your Adjusted Gross Income. The amount of federal income tax you pay is computed with the aid of a “table” reflecting your filing status. For instance, here is the example of year 2006’s Table 1 for Married Individuals Filing Joint Returns and Surviving Spouses: If Taxable Income is: The Tax is: Not over $15,100 10% of the taxable income Over $15,100 but not over $61,300 $1,510 plus 15%* of the excess of $15,100 Over $61.300 but not over $123,700 $8,440 plus 25%* of the excess of $61,300 Over $123,700 but not over $188,450 $24,040 plus 28%* of the excess of $123,710 Over $188,450 but not over $336,550 $42,170 plus 33%* of the excess of $188,450 Over $336,550 $91,043 plus 35%* of the excess of $336,550 * These percentages are commonly referred to as your “marginal tax rate.”

With the use of the correct Table (given your filing status) to help determine your marginal tax rate, you can begin to estimate the amount of the tax you will pay on a Roth 401(k) contribution. But a determination of the actual amount of tax attributable to the loss of the standard 401(k) deduction is much more complicated. There is a phase-out of certain types of exemptions and tax credits as your income increases. Tax credits, e.g., Hope and Lifetime Learning Credits, Earned Income Credit, Childcare Credits, etc., tend to phase out at lower levels of Adjustable Gross Income. Certain deductions and exemptions, particularly the Personal Exemption, phases out at much higher income levels. Deductions for other items (uninsured medical expense, casualty losses, and miscellaneous deductions) are subject to a threshold percent of Adjustable Gross Income before being deductible. Because the loss of a deductible 401(k) contribution will increase your Adjusted Gross Income which in turn can result in lost tax credits or exemptions, you could pay an increased amount of tax greater than the amount of the Roth 401(k) contribution multiplied by your marginal tax rate per the tax table. A good rule of thumb is that the loss of personal exemptions or tax credits will translate into an additional tax of 5% to 10% of your Roth 401(k) contribution above the applicable table rate. In other words, if your table tax rate is 28%, the tax cost could be 33% or 38% of the Roth 401(k) contribution. The Roth 401(k)’s effective tax rate could make that contribution less advantageous given The General Rule discussed earlier. Confused? This concept is best understood by modeling your tax return with and without the Roth 401(k) contribution and comparing the two results. Your CPA or a tax preparation program would be helpful in this regard. What Is Your Future Tax Rate? Even if tax law was not to change during your retirement from what it is now, some taxpayers should be cognizant of the impact taxable income has on the amount of social security income that will be taxable. Just as a Roth 401(k) contribution can result in an increase in the effective rate at which these contributions will be taxed, a qualified distribution from a Roth 401(k) can reduce the effective tax rate of lower income taxpayers. Many taxpayers do not realize that up to 85% of their Social Security can be taxed as ordinary income—and it is not because they might have W-2 wages while receiving Social Security payments. If the total amount of reportable income (from all sources) and Social Security payments exceed a certain amount (based on filing status), then up to 85% of Social Security payments will be taxable income. Qualified distributions from a Roth account are not reportable as income and could lower or eliminate the amount of Social Security payments that are taxable—effectively lowering the amount of taxes you pay beyond the tax rate that would have been applied to fully taxable distributions from a traditional 401(k). The Required Minimum Distribution Assuming you roll your Roth 401(k) account balance into a Roth IRA at retirement, your Roth IRA will not be subject to Required Minimum Distributions. Starting with the year in which you reach age 70½, you are required to take a minimum distribution from all types of tax- favored retirement accounts except the Roth IRA. This creates an advantage that can argue for the Roth 401(k) contribution despite The General Rule should you anticipate your tax rate will be lower in retirement than it will be when the Roth 401(k) contribution is made. Just as there is a benefit to tax- favored compounding for accumulation of retirement assets, there is a further benefit in postponing the recognition of taxable income. The longer you can go without withdrawing money from a tax-favored account, the greater the accumulation of over-all wealth.

You begin to unwind tax-deferred compounding when taking Required Minimum Distributions. In a Roth IRA, the tax-free compounding never has to be curtailed during your lifetime and that of your spousal beneficiary! Your non-spousal beneficiary must take Required Minimum Distributions upon inheritance of your Roth IRA, but he or she will continue to enjoy tax- free distributions (assuming the distributions are “qualified.”) Investors who have prepared well for retirement often find that they must either take Required Minimum Distributions sooner than they would otherwise prefer, or they must take Required Minimum Distributions in a greater amount than is needed for their retirement income. Lump sum distributions become subject to taxation and after-tax distributions not needed for current cons umption are invested within a taxable account. The Roth IRA minimizes, if not eliminates altogether, the need to take distributions and keeps investments within a tax-free environment. The Roth 401(k) can be an effective estate planning tool. ADP Test Failures Certain participants of 401(k) plans are designated as Highly Compensated Employees, or HCEs. Often times, HCEs are limited in the percentage of their compensation they can defer. Because the rules for the amount of 401(k) deduction that is possible do not differentiate between a Roth 401(k) and a traditional 401(k), the Roth 401(k) effectively allows such HCEs to defer a higher dollar amount of compensation. Assume an effective tax rate of 35%. If the rate at which you would pay taxes on your Roth 401(k) contribution in the current year is the same rate at which you would pay taxes on traditional 401(k) withdrawals in the future, The General Rule states that the after-tax value of a traditional 401(k) distribution is equal to the Roth 401(k) distrib ution. A $1,000 Roth 401(k) contribution is effectively a $1,538 taxdeductible 401(k) contribution. If you are an HCE who cannot defer the maximum dollar amount you would like because of ADP test failures, the Roth 401(k) effectively increases the amount you are deferring. This same concept applies to the participant who is not adversely impacted by the ADP test and can defer the maximum dollar amount of deferral ($15,000 in 2006 plus a $5,000 “catch-up” contribution for participants age 50 or older.) Assuming again a 35% tax bracket, a $20,000 contribution has the economic equivalence of a $30,769 traditional 401(k) contribution. ************ The remainder of this writing lists some Frequently Asked Questions about the Roth 401(k). How does a traditional 401(k) work? Currently, a 401(k) plan allows participants to place a portion of their income into a 401(k) retirement account on a pre-tax basis. The contribution is subject to social security taxes. The participant does not pay tax on the income that the participant contributes to the plan. The account grows on a tax-deferred basis. The participant does not pay tax as the account increases due to interest or investment growth. However, the participant is taxed on both the contributions and earnings the participant later withdraws from the account. How is a Roth 401(k) different? If an employer adds the Roth 401(k) feature to a 401(k) plan, a participant may choose to have a portion of the participant’s salary allocated to a Roth 401(k) account on a post-tax basis. Thus, contributions to the account are taxed. However, the money in the account grows on a tax- free basis. Ultimately, if the distribution meets the “qualified distribution” rules discussed below, the participant will not pay taxes on any amount the participant withdraws from the account.

Are Roth 401(k) contributions in addition to traditional 401(k) contributions? No. The 401(k) limits remain the same. Participants may contribute to a Roth 401(k), a traditional 401(k), or a combination of both during any election period if the Plan so allows, but participants may not contribute more than the 401(k) limits. In 2006, a participant may contribute up to $15,000 to a 401(k). Participants age 50 or over may contribute an additional $5,000 ‘catch-up’ amount. Can I split my contributions between the Roth and traditional 401(k) contributions? Yes, in any proportion you choose. Can I change my decision about whether the contribution is a Roth or traditional 401(k)? Once a deferral has been deducted from your paycheck, the decision is irreversible. Pursuant to operational restrictions established by your Employer, you can change your decision about the type of contribution for contributions not yet made. When may money be withdrawn tax-free from a Roth 401(k)? To avoid income tax on earnings, the withdrawal must be a “qualified distribution.” A qualified distribution is generally any payment made (a) after the 5-taxable- year period and (b) on or after age 59 1/2, due to death or due to disability. The 5-taxable-year period begins the earlier of (a) the first year a participant contributes to a Roth 401(k) under the employer’s 401(k) plan or (b) the first year the participant contributes to a designated Roth account that is rolled into the emp loyer’s plan. There is no exception to this “5- year rule.” Will my Employer’s Match be deposited into my Roth 401(k))? No. Even though you might designate your deferral as a Roth 401(k) contribution, all contributions from your Employer, and their inve stment earnings, will be taxed as ordinary income upon distribution. What are the primary benefits of a Roth 401(k)? Asset Protection Planning: Assuming investment growth is constant, a participant will have, dollar for dollar, more income for distributions net of taxes in a Roth 401(k) than in a traditional 401(k). This is because earnings grow tax- free and qualified distributions are income tax-free. Accordingly, an account free of tax upon withdrawal is more “valuable” than an equivalent sized account that is subject to tax. Additionally, amounts in a 401(k) plan or a rollover IRA are not subject to creditor claims. Rolling a Roth 401(k) over into a Roth IRA creates a rollover IRA. Estate Planning: Like a traditional 401(k), a Roth 401(k) is subject to minimum distribution at 70 1/2. However, if a participant rolls a Roth 401(k) into a Roth IRA, the participant may preserve the account for heirs as an income-tax-free legacy if the 5-year rule is met because there is no minimum distribution requirement in a Roth IRA. Currently, Roth IRA income limits prevent individuals with incomes currently over $100,000 (married filing jointly) from converting an IRA to a Roth IRA. These Roth IRA income limits do not apply when a Roth 401(k) is rolled over to a Roth IRA. Thus, a participant may take advantage of the higher contribution limits of the Roth 401(k) during working years, roll the account over to a Roth IRA, and let the balance grow tax-free until the participant dies. If the participant’s spouse treats the Roth IRA as the spouse’s own and does not take distributions from the account, the participant’s spouse can name the heirs as beneficiaries and continue to let the money grow tax- free until the participant’s spouse dies. Thus, compounded tax- free growth could be for a very long time. Generally, at 7% interest, tax deferred or tax-free assets double in value every 10 years. Beneficiaries generally receive the balance income tax- free as either a lump sum or life annuity. The Participant should seek estate tax planning advice to minimize potential estate taxes. Choice: At retirement, if a participant has both a Roth 401(k) and a traditional 401(k) account (or rollover IRA account), the participant may choose in any particular year whether to withdraw tax- free money from

the Roth 401(k) or taxable money from the traditional 401(k). Thus, if tax rates for the participant are particularly low one year, it might be a good year to withdraw traditional 401(k) money because the tax due will be low. Alternatively, if a participant knows that the tax rate for a particular year will be high because tax rates are increased or the participant has other taxable income, a withdrawal from the tax- free Roth 401(k) might be more beneficial. Social Security Benefits: An individual pays tax on up to 85% of social security benefits if “other” income received at the same time as social security benefits reaches certain limits. Distributions from a Roth 401(k) are not considered other income for social security benefits purposes. Distributions from a traditional 401(k) and other investments are considered other income. For participants anticipating other income above approximately $45,000 per year, the tax on social security benefits is not a factor in choosing a Roth 401(k) because social security benefits for these participants will likely be taxed at the highest rate due to the other income. However, for participants anticipating other income lower than that amount, savings in social security benefits taxes may be a factor in choosing to invest in a Roth 401(k). The participant can receive more income through the Roth distributions without increasing the income tax on the participant’s social security benefits. This leaves more social security benefits net of tax than if the participant had invested in a traditional 401(k) account. When is the tax savings between a traditional and Roth 401(k) not a factor? If a participant expects the participant’s current and retirement tax rates to be the same, there will be no difference in tax savings between the traditional and Roth 401(k). However, the Roth 401(k) may still be more attractive than a traditional 401(k) for asset protection or estate planning purposes. Why choose a Roth 401(k) instead of a Roth IRA? The two primary reasons to choose a Roth 401(k) instead of a Roth IRA are: (1) the contribution limits are much higher than those for a Roth IRA, and (2) the ability to contribute to a Roth IRA is phased out as income increases. In 2006, a participant may contribute up to $15,000 to a Roth 401(k). The Roth 401(k) catch-up contribution is $5,000 ‘catch-up’ amount. In 2006, a Roth IRA contribution is limited to $4,000 (plus an additional $1,000 ‘catch-up’ amount for participants age 50 or older). Contributions to a Roth IRA are no longer possible under current law when modified adjusted gross income reaches $160,000 (married filing jointly). In contrast, income limits do not prevent contributions to a Roth 401(k). Can Roth 401(k) participants contribute to a Roth IRA? Yes, as long as the participant’s modified adjusted gross income does not exceed the current Roth IRA income limit of $160,000 (married filing jointly). Can a participant roll a Roth 401(k) from a former employer into a new employer’s Roth 401(k) plan? Yes. The 5-taxable- year period continues from the year the participant first contributed to the Roth 401(k) of the former employer. Can a participant roll a Roth 401(k) over to a Roth IRA? Yes. Can a participant convert a traditional 401(k) to a Roth 401(k)? No. The Roth 401(k) is available only for contributions after December 31, 2005. What should a participant consider when choosing between a traditional 401(k) and a Roth 401(k)? The choice between a traditional or Roth 401(k) depends to some extent on a participant’s tax situation now and the participant’s expected tax situation in retirement. The chart below summarizes information about each feature that may assist a participant in choosing how to allocate contributions.

Traditional 401(k) Contributions are pre- income-tax Earnings are income tax-deferred Distributions are taxable as income Minimum distributions must begin at age 70 1/2, including amounts rolled over into a traditional rollover IRA Reduces adjusted gross income, which may allow participants to qualify for other tax savings that are tied to adjusted gross income (retirement saver’s credit, itemized deductions) May increase social security benefits taxes, but not for high income retirees Tax savings resulting from the deductible contribution can be invested elsewhere. The 15% capital gains tax rate should be considered

Roth 401(k) Contributions are post- income-tax Earnings are income tax- free so long as distributions are qualified Qualified distributions are income tax-free Minimum distributions must begin at age 70 1/2, but can be avoided by rolling over into a Roth IRA Does not reduce adjusted gross income

Will not increase social security benefits taxes No tax savings at the time of the contribution

TRADITIONAL 401(K) VS. ROTH 401(K)
Working Tax Rate Tax Rate Retirement tax Rate Cashflow Allocation Working Investment Return Retirement Investment Return Scenario #1 35.0% 35.0% $20,000 8.5% 6.0% Annual Contributions Traditional ROTH 20,000.00 $ 13,000.00 21,700.00 $ 14,105.00 45,244.50 $ 29,408.93 70,790.28 $ 46,013.68 98,507.46 $ 64,029.85 128,580.59 $ 83,577.38 161,209.94 $ 104,786.46 196,612.79 $ 127,798.31 235,024.87 $ 152,766.17 276,701.99 $ 179,856.29 321,921.66 $ 209,249.08 209,249.08 $ 209,249.08 341,236.95 361,711.17 383,413.84 406,418.67 430,803.79 280,022.47 $ $ $ $ $ $ 221,804.02 235,112.26 249,219.00 264,172.14 280,022.47 280,022.47 Scenario #2 35.0% 25.0% $20,000 8.5% 6.0% Annual Contributions Traditional ROTH 20,000.00 $ 13,000.00 21,700.00 $ 14,105.00 45,244.50 $ 29,408.93 70,790.28 $ 46,013.68 98,507.46 $ 64,029.85 128,580.59 $ 83,577.38 161,209.94 $ 104,786.46 196,612.79 $ 127,798.31 235,024.87 $ 152,766.17 276,701.99 $ 179,856.29 321,921.66 $ 209,249.08 241,441.24 $ 209,249.08 341,236.95 361,711.17 383,413.84 406,418.67 430,803.79 323,102.84 $ $ $ $ $ $ 221,804.02 235,112.26 249,219.00 264,172.14 280,022.47 280,022.47 Scenario #3 35.0% 40.0% $20,000 8.5% 6.0% Annual Contributions Traditional ROTH 20,000.00 $ 13,000.00 21,700.00 $ 14,105.00 45,244.50 $ 29,408.93 70,790.28 $ 46,013.68 98,507.46 $ 64,029.85 128,580.59 $ 83,577.38 161,209.94 $ 104,786.46 196,612.79 $ 127,798.31 235,024.87 $ 152,766.17 276,701.99 $ 179,856.29 321,921.66 $ 209,249.08 193,152.99 $ 209,249.08 341,236.95 361,711.17 383,413.84 406,418.67 430,803.79 258,482.28 $ $ $ $ $ $ 221,804.02 235,112.26 249,219.00 264,172.14 280,022.47 280,022.47

Year First Contributin 1 2 3 4 WORKING YEARS: 5 6 Annual Contributions 7 8 9 10 After-Tax Lump Sum Equivalent 11 12 RETIREMENT YRS: No 13 Contributions 14 15 After-Tax Lump Sum Equivalent

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

$ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $

YRS OF MONTHLY INCOME

Monthly Income & Principal Depleted 10 $2,333.52 $2,333.52 15 $1,555.68 $1,555.68 20 $1,166.76 $1,166.76

$2,692.52 $2,333.52 $1,795.02 $1,555.68 $1,346.26 $1,166.76 Traditional 401(k) is better

$2,154.02 $2,333.52 $1,436.01 $1,555.68 $1,077.01 $1,166.76 Roth is better