In the 401(k) world there has for many years been the option for plan participants to contribute to Roth 401(k) accounts, rather than traditional 401(k) account. For contributions to Roth accounts, no income tax deduction is provided, but (subject to certain requirements) the Roth account permits income-tax-free distributions after age 59-1/2 years.
401(k) accounts, and other types of plan accounts, are governed by ERISA. Under ERISA, the standard of care for investment advice is that of the Prudent Investor Rule. This is a tougher duty of care than that generally applicable to RIAs or to BDs, in which only a “reasonable basis” for investment decisions is required. (Although, SEC staff has stressed the need to carefully consider fees and costs, in recent guidance that has been issued.)
The Prudent Investor Rule (PIR), in turn, requires minimization of idiosyncratic (diversifiable) risk, and avoiding “waste” of the account owner’s assets. Waste can occur through paying high fees and costs, or by unnecessarily paying taxes.
A 25-year old plan participant (with a 40+ or greater likely remaining work life expectancy, until retirement), likely possesses a relatively low (relative to that seen in later years of the plan participant’s life) applicable marginal income tax rate. If the 25-year-old has both a traditional 401(k) account (perhaps funded by employer contributions) and a Roth 401(k) account, how should these accounts be invested?
Clearly the answer, given the very long time horizon until the funds are needed (it is assumed, for purposes of this discussion, that early withdrawals are not planned), is to place the asset classes with the highest expected returns (over the long term) in the Roth account. This maximizes the income-tax-free growth of that account over time.
In the traditional 401(k) account would go any remaining asset classes. Including any allocation to fixed income investments (such as bond funds), which possess a substantial likelihood of underperforming most equity investments (such as stock mutual funds) over very long periods of time.
The DOL should encourage providers of investment solutions to defined contribution plans where both “traditional” and “Roth” options exist to develop and implement tax-efficient asset placement, so as to adhere to the Prudent Investor Rule’s often-overlooked requirement to minimize the tax drag upon investment returns. The DOL should encourage providers to address this often-overlooked requirement of the Prudent Investor Rule through software and other solutions that undertake tax-efficient asset placement.
In the interim, it is up to financial advisers to provide education and advice to plan participants. And to adopt educational practices that encourage proper asset placement in the various accounts the client possesses. And to adopt systems (and software) that better enable a “default” investment solution, such as a target date fund, to be modified so that a more aggressive asset allocation occurs in the Roth account, at least for most plan participants.
This page represents the personal views of Ron A. Rhoades, JD, CFP®, and does not necessarily reflect the views of any institution, firm, organization, motley crew of pirates, cult, or gang, to which Ron has ever belonged to or ever been kicked out of.
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