If someone told you that you could provide tax free revenue for your beneficiaries over their lifetimes, you would probably dismiss this as "too good to be true."  That would be a shame, because it is an extraordinarily good thing and, beginning in 2006, this benefit that had previously been restricted to Roth IRAs has been expanded to Roth 401(k) Plans.  

             Whereas traditional 401(k) Plan elective deferrals are made on a pre-tax basis, Roth 401(k) deferrals, like Roth IRA contributions, are made on an after-tax basis and generate earnings excludable from gross income with respect to a qualified distribution. The after-tax nature of the Roth 401(k) deferrals means that you pay the tax now and for qualified distributions, not only the contribution, but all future earnings thereon, are fee from tax. The annual limit on 401(k) elective deferrals applies to Roth 401(k) elective deferrals, not the IRA contribution limit.  Accordingly, a participant may make a Roth 401(k) deferral of up to $15,000 (with an additional $5,000 catch-up contribution for participants who have attained age 50) as compared to the $4,000 Roth IRA limitation (the 2006 limit).  Whereas an individual is subject to income limitations in order to be eligible to contribute to a Roth IRA, a 401(k) participant may make designated Roth deferrals without regard to the participant's income.  The benefits of planning with a Roth 401(k) require that distributions from the account or a rollover Roth IRA be qualified distributions. This means that the distribution not being made earlier than the participant's attaining age 59½, death or disability and 5 years having elapsed from the participant's first Roth 401(k) elective deferral.

             What kind of tool can this be in your estate plan?  Because a decedent's gross estate must exceed $2,000,000 before it is subject to federal estate tax, this can be a very powerful tool for Roth 401(k) Plan participants at all income levels.  For example, assume you are a 40-year-old wage earner and you elect to defer $5,000 each year through age 65 as Roth deferrals to your employer's 401(k) Plan. If your investments over the 25 years before retirement at age 65 earn 7% on average, you will accumulate $316,000.  Account balances in 401(k) Plans are subject to the lifetime minimum distribution rules.  In other words, the Plan must pay your account to you over your life expectancy or faster.  You can avoid required minimum distribution during your lifetime by rolling this $316,000 from your employer's 401(k) Plan to a Roth IRA.  For this rollover, the Roth 401(k) deferrals cannot be commingled with any traditional 401(k) deferrals.  This should not be a problem because the Plan must separately account for the Roth 401(k) deferrals and earnings on these deferrals.  The Roth rollover IRA is not required to make distribution to you during your lifetime. This is a major difference between Roth IRAs and traditional pre-tax contribution IRAs from which distributions must commence upon attaining age 70½ and continue over your lifetime.

             Higher income earners could and should defer more than the $5,000 used for this example. The benefits for greater contributions can increase exponentially.  Younger income earners (those starting in the workforce in their 20's) have the power of compounding and can achieve exceptional results over their working careers. For example, if instead of waiting until age 40 as in the example, the participant had started at age 25, the benefit at age 65 would be approximately $1,000,000.

             The distributions from the Roth rollover IRA, including both principal contributions and the income earned, are made income tax free to you and to your beneficiaries. From an estate planning perspective, this allows you to have an asset that is available to you, at your discretion, during your lifetime.  The IRA is also generally not available to satisfy creditor claims if you are sued or file bankruptcy. You can use other savings, assets and income and allow the Roth rollover IRA to continue to grow income tax free. The IRA is not a probate asset, so the beneficiary or beneficiaries that you identify will have immediate access to the IRA funds at your death. You may designate your spouse as your IRA beneficiary and at your death, he/she may make your IRA his/her own so that your spouse has the same flexibility and options during his/her life as are available to you.  If your spouse survives you and does not need/want the IRA funds, the income tax free accumulation continues until his/her death.  At the death of the Roth IRA owner, then the distributions must commence and must be made over the life expectancy of the non-spouse beneficiary (although the distributions may be faster if the beneficiary desires).   

            Again consider the case of the 40 year old who defers $5000 per year for 25 years and accumulates $316,000 at age 65.  Assume that he/she retires at age 65 and rolls the $316,000 to a Roth IRA and continues to earn 7% for 10 years until age 75. At age 75, the $316,000 will have grown to approximately $621,000.  From age 75 through his/her death, let's assume that the individual withdraws all annual earnings (approximately $43,000 per year and all tax free) until he/she dies. If the individual dies at age 80 and names a child age 50 as the beneficiary, the child could receive approximately $47,900 income tax free each year for the child's lifetime. Imagine how beneficial this would be for your children. This would be supplement their income and retirement and assist them at a time when your grandchildren are entering college, starting graduate school or entering the workforce and in need of assistance with the purchase of a home.  These distributions may enable your children to maximize their own Roth 401(k) deferrals and continue the cycle for your grandchildren.  

            Too good to be true? Not at all. This is available right now if your employer has added the Roth feature to its 401(k) Plan. The next step is up to you to go to your payroll office and start making Roth elective deferrals.  If your employer does not have a Roth 401(k) feature, tell them about it!  Naysayers may point out that (absent Congressional action) the Roth 401(k) features of the tax law "sunset" after December 31, 2010. This sunset feature is Congressional slight of hand in its 2001 tax legislation to comply with budget limitations.  Do not wait until 2011 or until Congress acts.  You will have lost 5 years of Roth deferrals (for a 50-year old that could be as much as $100,000). Begin to take advantage of the current law at the present time and make sure that your elected officials know that you want to extend the Roth 401(k) benefits to your children and grandchildren. You will have started an income tax free legacy for your descendants. 

For additional information, please contact:

David M. Mosier, Esq.
Knox, McLaughlin, Gornall & Sennett, P.C.
120 West Tenth Street
Erie, Pennsylvania 16501-1461
Telephone (814) 459-2800; Fax (814) 453-4530
E-mail: dmosier@kmgslaw.com