Leveraging – A Hidden Advantage of Roth 401(k) Accounts

Fall 2017Articles For Your Benefit

There have been numerous articles published about the advantages of Roth IRAs and Roth 401(k) accounts. While no tax deduction is available for contributions to Roths, in general, distributions of both principal and earnings are tax-free. When combined with the ability for leveraging (subject to payment of unrelated business income tax (UBIT)), some interesting planning and tax saving opportunities arise. One such opportunity may be the ability to leverage a Roth account to enhance the deferral and tax-free distribution power of the Roth.

As a threshold matter, it is preferable to leverage a Roth 401(k) rather than a Roth IRA. While it may be possible to accomplish a similar result in a Roth IRA, Section 408(e)(4) of the Internal Revenue Code prohibits a pledge of IRA assets as security for a loan, which complicates the situation. While it is not clear whether the prohibition applies to IRA investments themselves (as opposed to security for third party loans), it is best to avoid leveraging in Roth IRAs. However, unlimited rollovers are permitted from IRAs to qualified plans such as a 401(k) plan, and there are not significant impediments to use of a Roth 401(k) for leveraging purposes. Undoubtedly, not every individual is able to dictate the provisions of the Roth 401(k) sponsored by their employer. However, business owners and those with independent consulting and/or directorship income have the ability to establish their own 401(k) plans with a Roth 401(k) feature.

Leveraging is permitted in 401(k) plans, but earnings derived as a result of the leveraging are taxed as UBIT. It is important that any individual engaged in leveraging be aware of the tax rules for computation of UBIT before engaging in any leveraging transaction. The specific issue is that the tax is computed based upon the total earnings of the account, including the non-leveraged assets. This rule is best illustrated by the following example:

The result in the forgoing example is somewhat counter-intuitive to this article’s focus insofar that while only $30,000 was earned on the borrowed funds, the result is that $47,000 is taxed. It occurs because the UBIT is computed on a percentage of the total earnings of the fund. While it is common to borrow to make a specific investment, money is fungible and the taxable income is computed as if the borrowed funds were allocated to all of the investments on a proportionate basis. (Please note that this is a simplified illustration; the actual calculation of UBIT is more complex involving the calculation of “average acquisition indebtedness.”)

However, the inverse of the forgoing rule is also true and can be used to the taxpayer’s advantage in a situation where the borrowed funds significantly outperform the non-leveraged assets. This opportunity is illustrated in the following example.

As illustrated above, the opposite result occurs here. By pairing the “borrowing” with other assets that do not produce ordinary income (as opposed to capital gains) the amount upon which tax is paid is reduced from the $20,000, which is the net income that results from investment on the “borrowed” funds, to $7,000. (It should be noted that UBIT is also payable on capital gains producing property; however, if the “acquisition indebtedness” is eliminated more than one year before the sale, the gain is not subject to UBIT.)

While minimizing taxable income on borrowed funds is desirable, it is only a technique to maximize the real “hidden” benefit of leveraging in a Roth 401(k) – which is the tax-free earnings generated on borrowed funds.

In the last illustration, the net investment earnings on the “borrowed” funds was $20,000. Assuming that $3,000 in tax is paid on the $7,000 of UBIT generated, then the Roth 401(k) is net $17,000 “richer” than it otherwise would be without leveraging. All things being equal, all of the subsequent earnings produced by the additional $17,000 will never be taxed. If we assume that these “extra” dollars earn interest at 5 percent, compounded annually, after 20 years the $17,000 will have grown to more than $45,000. In other words, by borrowing a single $1,000,000 in one year, the Roth 401(k) can generate more than $45,000 in tax-free income by simply investing the resulting net income in conservative investments.

These results shown above can be dramatically improved by borrowing every year. In fact, we estimate that almost an additional $600,000 in tax-free income could be generated over a 20-year period, by borrowing $1 millon each year under circumstances shown in the second illustration.

Undoubtedly, those results are a product of utilizing a somewhat optimal set of facts, particularly in connection with the “mix” of assets for leveraging purposes. In the first case, assets that produce capital gains, rather than ordinary income, may not be part of the underlying plan’s overall investment portfolio. Even when such assets are part of the investment portfolio, the investment mix may not produce optimal tax results. However, with the use of multiple plans, each of which is its own taxpayer, a business owner will have greater flexibility to structure the optimal investment mix. Because a trustee-to-trustee transfer of assets among plans is generally permitted, it may be easier to achieve the desired combination of income and capital gains producing properties than you might otherwise think.

There are other challenges, however. One is the complexity of UBIT calculation. While the examples provided above are intentionally based on a simple, straightforward set of facts and assumptions, it is unlikely that the actual situation will be so straightforward. Another challenge is to properly isolate the leveraged and non-leveraged assets. While it is possible to write a plan to segregate Roth 401(k) assets from non-Roth assets for internal plan allocation purposes, it is unclear whether the asset segregation language will be respected by the IRS for purposes of UBIT calculations. This issue can likely be minimized by maintaining separate plans as noted above. If non-owner employees also participate in one of the plans, care must be taken to provide the same rights, benefits and features to rank and file participants as are available to those key participants desirous of leveraging.

Without question, the benefits of leveraging in a Roth account require complex planning and structuring. Implementing this type of planning should be performed with the assistance of an experienced pension and retirement planning professional.