A FAILSAFE ROTH PLAN
In decades past, most employer pension plans fell into the category of a Defined Benefit Plan (“DB plan”). That is, when an employee retired as a beneficiary of a DB Plan, he or she received a monthly payment for his or her retirement life span. The DB plan payment amount was determined by formulas driven by the employee’s length of service and compensation while working for the employer. The employee benefit was independent of the pension plan’s financial performance or the plan’s investments.
Today, the numbers of DB Plans have declined dramatically and have been replaced by Defined Contribution Plans (“DC Plans”). Defined benefits are not part of a Defined Contribution Plan – the available distributions from a DC Plan are determined by the magnitude of contributions and the plan’s earnings. Once a Defined Contribution Plan beneficiary retires, there are minimum withdrawal rules, but nothing that prevents a beneficiary from making withdrawals such that DC Plan assets are fully spent or depleted before that retiree dies. The major shift from DB Plans to DC Plans in the USA coupled with lower average returns, poor savings rates, higher healthcare costs, and greater longevity has created a nation worried about running out of money during retirement.
In a prior blog article, we described an approach that guarantees that an IRA Plan beneficiary will not outlive his or her savings. That approach is the “Failsafe Strategy.” To implement the strategy, a person with a traditional Individual Retirement Account (“IRA”) (or other qualified DC Plan) divides his IRA assets into two “buckets.” The first bucket distributes a fixed annual amount from the IRA from the start of retirement to a future annuity start date (e.g., between ages 70 to 85). At the end of the first bucket’s tenure, there can be few or no assets in the IRA. The second bucket is a Qualified Longevity Annuity Contract (“QLAC”) that pays an annual benefit (e.g., starting at age 85) for life. The tax rules allow a withdrawal from a traditional IRA Plan to be tax exempt if invested in a QLAC. Accordingly, the QLAC premium amount was withdrawn from the IRA before or at age 70 and the QLAC lifetime annuity benefits were determined at the purchase date. Click here to see a calculator we developed especially for developing this kind of plan.
ROTH PLANS – NEW KIDS ON THE BLOCK
Traditional DC Plans come in a variety flavors and scents – examples include an IRA, a 401(k), a 403(b), a 457(b), a SEP IRA, a Keogh, and a SIMPLE plan. Each of these plans shares common attributes:
· Each has its definition of who can contribute and the contribution limits of the plan;
· The contribution is with pre-tax compensation or earnings;
· Retirement distributions from the plan are 100% taxable income to the beneficiary.
In 1997, Roth IRAs became a new Defined Contribution Plan option. Next, in 2001 Congress created Roth 401(k), Roth 457(b) and Roth 403(b) DC Plans. The Roth DC Plans were made permanent in 2006. Since then, the plan’s popularity has grown. For example, there were over $500 billion in Roth IRA assets in 2013.
So, what is different about a Roth versus a traditional DC Plan?
· The contributions to the Roth plan are with after-tax compensation or earnings;
· Retirement distributions from the plan are 100% tax-exempt to the beneficiary.
The income earned inside the Roth DC Plan is also tax exempt – just like a traditional Defined Contribution Plan. Generally, the implementation rules are the same. For example, both Roth and traditional 401(k) plans are subject to the same Required Minimum Distribution (“RMD”) rules after the plan beneficiary reaches age 70½. There are important exceptions. Here is one: a traditional IRA is subject to the IRS RMD requirements, but a Roth IRA is not. This is an essential difference that enables us to create a Failsafe Roth strategy.
The 2014 QLAC regulations specifically exclude any distributions from a Roth Defined Contribution Plan. Of course, any distribution from the Roth Plan is already tax exempt. As a result, a distribution can be used by the beneficiary to buy any annuity. The problem is that distributions from that annuity, purchased outside of the Roth, will no longer be fully tax exempt. Instead, each distribution will include a return of the premium cost (which is not taxed) and the earnings that occurred inside the annuity (which is taxed).
The problem is solved by having a Roth IRA buy an annuity and be its beneficiary. In other words, the Roth IRA will divide its assets into two buckets. The first bucket will distribute cash to the beneficiary over a predetermined period – just like a traditional IRA. The second bucket is used to buy a deferred annuity with a distribution start date (e.g., age 85) just like with a QLAC annuity. Unlike a traditional IRA that distributes funds out of the plan to purchase a QLAC, The Roth IRA plan is the owner and beneficiary of the annuity. Annuity benefits are paid to the Roth IRA, which in turn, can distribute the cash receipts to the Roth IRA beneficiary. So doing, the Roth IRA distributions are fully tax exempt. By using a Roth DC plan to purchase the annuity, a beneficiary is not constrained by the $125,000 cap ($130,000 starting in 2018) which applies to a QLAC purchase.
An individual may have a Roth 401(k) plan and not a Roth IRA – or have both. To be sure, 401(k) plans have larger contribution limits. As a result, an individual’s Roth 401(k) plan can accumulate more savings during his or her working years than a Roth IRA. It is important to recognize that employer 401(k) plans are not uniform. Today, more than half employer-sponsored 401(k) plans allow an employee to elect either a Roth or a traditional plan.
Many - if not most - plans require that when an employee resigns, he or she may (or is required to) “rollover” the plan assets into an IRA or another 401(k) plan. Similarly, when an employee retires, there is a rollover requirement or option. Also, employer-sponsored plans will be administered by a trustee (also, called a custodian) such as Principal Financial or Fidelity. The investments available to the plan participant will be those approved by the employer from a list of investments often managed by the trustee’s related fund managers. A dozen or fewer choices are typical.
When a rollover option or requirement happens, generally it makes sense to move the assets from the Roth 401(k) to a Roth IRA. (Note – rollovers done incorrectly can trigger tax and penalties. IRS Publications 560, 575 and 590A are helpful reading. Better yet, consult a tax expert before executing a rollover.) Even though a transfer to another Roth 401(k) is also a tax-free transfer, remember that a Roth 401(k) plan is subject the RMD required distributions whereas a Roth IRA does not have an RMD requirement. A non-IRA Roth DC plan could easily fail the RMD test if it holds both buckets – regular investment funds and an annuity. Assuming there are same investment options, there is no advantage of a rollover to a Roth 401(k) versus a Roth IRA.
Here's another reason for moving to Roth IRA rather than to a Roth 401(k). Before executing a rollover, the participant must choose a new trustee. This is an important choice. For example, Fidelity may offer a short list of annuities that underperform a long list of annuity choices at Principal. The choice of a plan trustee is a choice of the kind of deferred annuity that is available. It is important to note that Roth IRA trustees are available that allow “self-directed” investments by the beneficiary. A self-directed Roth IRA has a truly independent trustee that is agnostic about the purchases selected by the participant.
Many of the insurance companies selling annuities will create a Roth IRA to receive the rollover proceeds earmarked to purchase that company’s annuity contract. Once an annuity is targeted for purchase, it makes sense to ask the carrier if they offer the ability to create a Roth IRA to receive funds designated to buy their annuity. Creating a new Roth IRA is a service offered for nominal or no cost.
Please note that a Roth 401(k) rollover can be to more than one Roth IRA. It is possible to have one Roth IRA to hold the assets to fund the first phase of retirement (i.e., the first bucket) and a second Roth IRA to hold the life annuity to fund the second phase of retirement (i.e., the second bucket). Such a breakup might be motivated by selecting a plan sponsor with a good investment track record for the first bucket and using a self-directed plan or an insurance company trustee to acquire the second bucket’s deferred annuity.
A Roth 401(k) (or a Roth IRA) can duplicate the same Failsafe strategy available to a traditional DC Plan that distributes funds to buy a QLAC annuity. While there are a couple more steps, they are not complicated:
· Determine the two phases of retirement funding;
· Divide the Roth DC Plan assets into the two buckets of retirement assets;
· Migrate the two buckets of assets into one or more Roth IRAs;
· Purchase a deferred life annuity in one Roth IRA;
· Distribute bucket one assets during the first phase of retirement;
· Distribute bucket two assets (annuity receipts) during the second phase of retirement.
Because the Roth IRA buys a life annuity, the participant collects income for however long he or she may live. Accordingly, it is impossible to outlive one’s savings.