When 401(k) plans aren’t the best option

The accounts are attractive because they offer efficient payroll-withholding deposits, deferred taxation on principal deposits and investment earnings, and the ability to pool deposits with other participants to buy mutual funds at wholesale expense ratios.

Although pretax savings and tax-sheltered earnings are alluring, the question remains: Are those factors overshadowing the retirement realities for affluent 401(k) participants and participating plan sponsors?

During the past 30 years, people have lost sight of the 401(k)’s original purpose and have forgotten to test its fundamentals against changing economic and tax environments.

This presents significant risk for executives in the upper income-tax brackets. The 401(k)’s pretax benefit is premised on the idea that after an executive retires, he or she will move to a lower tax bracket and incur less tax on retirement savings plan withdrawals.

But for most executives, this won’t be true. They will retire in the maximum tax bracket and remain there through most of their retirement.

Executives typically participate in all or some of the following retirement savings vehicles: 401(k)s, individual retirement accounts, non-qualified plans and employee stock ownership plans. In each case, the Internal Revenue Service imposes required minimum distributions, which are taxed as ordinary income at the time of distribution.

The operative concept is “taxed as ordinary income at the time of distribution.” Those executives who are in high tax brackets when they receive their required minimum distributions will enjoy less of the pretax benefit that they bought into when they were contributing to their 401(k) account.

Given today’s tumultuous economy, with high-cost government bailouts and adventurous public-sector spending driving staggering fiscal deficits, a future increase in the maximum ordinary income tax rate can’t be discounted. For executives, it would mean paying even more taxes for their distributions.

Financial advisers with corporate executive clients should consider other viable retirement savings options in their retirement planning. One such option is an executive savings program, which simply is a custodial account set up at a trust company to which the executive makes scheduled direct deposits through the efficiency of payroll withholding.

Unlike a 401(k), there are no limitations on contributions made to an ESP. All contributions are made on an after-tax basis.

A big advantage of an ESP is that upon withdrawal, earnings will be taxed at the more favorable long-term capital gains rate — currently 15% — with proper investment asset allocation.

Companies can 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. A common investment approach for this type of program would be lifestyle funds, using low-cost index funds as the underlying investments.

Under an ESP, company responsibilities and cost are simplified and in some cases nonexistent as compared with a qualified retirement plan.

There are no requirements for a company plan document, IRS plan approval, annual 5500 filings, or annual testing. Money placed in this program isn’t subject to company creditors.

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

Companies looking to strengthen executive benefits to boost recruitment and retention — with lower overhead — should look to expanding their retirement benefit portfolios to include ESPs.

Robert W. Kumming is senior vice president of Reliance Trust Co.

Related Topics: Retirement Watch