ADP testing for Roth Deferrals

[KevinMc]

Can anyone help me out with adp testing, I have a HCE who gets refunds and he wants to know if by making Roth contributions would that bypass the testing since its after tax?

[ETA Consulting LLC]

Can anyone help me out with adp testing, I have a HCE who gets refunds and he wants to know if by making Roth contributions would that bypass the testing since its after tax?

No, it is still falls under Section 401(k) of the Code.

Good Luck!

[401king]

The math, though, does make sense for HCE to contribute on a Roth basis (if everything else is constant).

For instance, assume they would pass with the HCE contributing $10,000. He could make that contribution on a pre-tax basis ($10,000 straight). Or, he could make that contribution on a Roth basis ($10,000 after taxes). Both would lead to the same ADP.

Traditional: Assuming a 25% tax bracket & no growth (you can factor in growth, but the results are the same), he would have $10,000 in the account at retirement but pay $2,500 in taxes; only $7,500 net, but contributed $10,000.

Roth: Assuming a 25% tax bracket, $10,000 Roth contribution would be like contributing $13,333.33 in traditional money. As he would, at retirement, still have $10,000 to live on ($2,500 more than if he did pre-tax).

If the goal is to have more to live on at retirement, Roth may be better for an HCE who would be subject to refunds. If the goal is tax-savings, then it's best to forget I said anything. The hard part is convincing them that the tax savings now isn't better than the extra money at retirement - it's the [indeterminable] variables that will prove which is better.

This math also holds true for individuals trying to max-out their 401k contributions. They will net greater results (with respect to how much they have to live on at retirement) if they contribute on a Roth basis.

[Mike Preston]

If there is no growth and no change in tax rates then all you are doing is prepaying the eventual tax. Dumb.

The Roth advantage is that qualifying growth is not taxed. If you remove growth from the equation you scuttle the reason for the Roth.

Ben Spater wrote an article on this issue when Roth's were first introduced. What it said and what your post said are in agreement: those who contribute the maximum available to them as Roth contributions essentially are making a contribution larger than otherwise available. It is not intuitive, but it is correct.

[401king]

If there is no growth and no change in tax rates then all you are doing is prepaying the eventual tax. Dumb.

Okay, so let's assume there is growth to show that the result is the same - a higher net balance.

$10,000 over 30 years at 6% would yield $57,434.91.

If the contributions were made pre-tax, the net value (after 25% taxes) would be $43,076.18.

If the contributions were made after-tax, the net value would be $57,434.91. Basically allowing 25% extra of the account to grow tax-free. The same net result as if he had contributed $13,333.33 in pre-tax funds, but the scenario assumes a $10k max to pass ADP so the individual cannot get that much in there.

Not necessarily the best plan for someone in a high tax bracket, like a lot of HCEs, but some may be in low enough brackets to warrant Roth contributions. Who knows where the brackets will fall in 10-30 years, anyway.

It's the exact same logic as saying someone who wants to max out would net a higher benefit contributing Roth. The only difference is that in this case the "max" is limited by ADP.

[ETA Consulting LLC]

but some may be in low enough brackets to warrant Roth contributions. Who knows where the brackets will fall in 10-30 years, anyway.

You're saying the same thing. "IF" you believe you'll be in a higher tax bracket in the future, then you'd benefit more from the Roth Election.

"IF" you believe tax rates will remain unchanged, then you're basically prepaying taxes (assuming you're forgoing that earnings on the taxes you just prepaid".

"IF" you believe you'll enter a lower tax bracket when you begin to receive the distributions, then go pre-tax (this has actually been the premise of the 401(k) plans for some time); especially given the flexibility to control the rate at which you receive distributions.

There is no one size fits all.

Good Luck!