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The 401(k) at 30

Have we been blinded by the pre-tax light?

By Robert W. Kumming

Since Section 401(k) of the Internal Revenue Code went into effect in 1980, the 401(k) plan has grown to be the largest private-sector retirement plan in the U.S. According to the Employee Benefits Research Institute and the Investment Company Institute, 50 million workers are participating in 401(k) plans, with $2.3 trillion in deposits.

It's easy to understand why these accounts are so attractive. They offer efficient payroll-withholding deposits, deferred taxation on principal deposits and investment earnings, and the ability to pool deposits with other participants' contributions to buy mutual funds at wholesale expense ratios.

But is the allure of pre-tax savings and tax-sheltered earnings overshadowing the retirement realities for 401(k) participants and participating plan sponsors? Quite possibly, because for participants, there‘s the downside of taxation, and there are penalties if funds are withdrawn before age 59 ½. They are also subject to required minimum distributions (RMDs) at age 70 ½. And both deposits and interest earnings are taxed at ordinary income tax rates at the time of distribution.

For plan sponsors, there is the ongoing cost of administering the plans through the guidelines of the ever-changing ERISA tax code, which includes annual legal and accounting fees to keep the plan in ERISA compliance. Further, most 401(k) plan sponsors with over 200 participants have to pay at least one full-time employee to run the plan.

At its inception, the 401(k) plan was designed merely to supplement a company's defined-benefit retirement plan. Over the past 30 years or so, people have lost sight of this purpose and have forgotten to test its fundamentals against changing economic and tax environments. This presents significant potential risk for executives in the upper income brackets. Pre-tax benefit is premised on the idea that after an executive retires, she will move to a lower tax bracket and incur less tax burden on retirement savings plan withdrawals.

For most executives, however, this will not be true. They will retire at the maximum tax bracket and remain there throughout most of their retirement. In many instances, executives typically participate in many retirement-savings vehicles, some of which have RMDs and are taxed at ordinary income tax rates at the time of distribution.

The operative concept is "taxed at ordinary income tax rates at time of distribution." Executives who are in high tax brackets when they receive their RMDs will enjoy less of the pre-tax benefit they bought into when they were contributing to their 401(k)s. Obviously, a future increase in the maximum ordinary income tax rate would result in these executives paying even more taxes for their distributions.

Will this happen? A Magic Eight Ball would likely say "I can't predict," and increasing ordinary income tax rates without some concessions for retirees would have a very disturbing effect on retirement income. But given today's tumultuous economy, such a measure cannot be discounted.

An alternative
But executives do have other options, including the executive savings program (ESP). This is a custodial account, set up at a trust company, to which the executive makes scheduled direct deposits through payroll withholding. Unlike a 401(k), there are no limitations on contributions made to an ESP. All monies deposited are made on an after-tax basis. A big advantage of an ESP is that upon withdrawal, earnings can be taxed upon withdrawal at the more favorable long-term, capital-gains rate (currently 17 percent).

Companies may also make matching deposits (considered for corporate tax purposes to be salary, thus creating an immediate deduction for the company) to the executive's account. With an ESP, the executive saves efficiently through payroll withholding and can dollar cost average into investments.

Under an ESP, company responsibilities and costs are simplified, and in some cases, nonexistent as compared to a qualified retirement plan. No company plan document, IRS plan approval, annual 5500 filings or annual testing is required.

A case in point
Here is an example of how an ESP works for an executive. Rob, age 55, is evaluating his retirement strategy and is concerned about the tax implications of his pre-tax qualified retirement plan. He stops participating in the company's 401(k) plan, sets up a custodial account through a trust company and elects to make payroll- withholding deposits to that account.

Rob's company has agreed to match his contribution to the ESP in the same amount he contributed to the company's 401(k) plan. When Rob retires, he has balances in the company 401(k) plan, a previous IRA and a non-qualified plan, all of which will be subject to ordinary income tax rates and some RMDs.

However, Rob also has an ESP account, so for retirement-income-distribution purposes he can draw down his more favorably taxed ESP account to meet his retirement-living needs until he is required to draw the federally mandated withdrawals on his pre-tax accounts at age 70 1/2.

By employing this strategy, Rob can minimize his tax exposure by delaying the drawdown of retirement income taxable as ordinary income until he is further along into retirement and has a higher likelihood of being in a lower tax bracket.

Setting up an ESP
The first step in setting up an ESP is typically an initial meeting between the company and an ESP provider to discuss program features and parameters.

Step two involves one-on-one meetings with the executives and an experienced enrollment team. During the meeting, each executive completes custodial account set-up forms, payroll-withholding forms and his investment-election form--similar to pre-tax plan setup. Once the custody account is established, the executive can view account activity 24/7 via a web-based link. The timeframe for setting up an ESP is typically within 60 days.

Properly established and managed, an ESP can develop a more robust and diversified retirement strategy for an executive. It provides easy and efficient participation, has no limits on contribution and is a buffer against rising tax rates.

Robert W. Kumming is senior vice president of Reliance Trust Company. Contact him at

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