To Roth or not to Roth in a DC plan — that is the question
Sept. 28, 2017
Proposals to cut individual and corporate taxes are making the rounds on Capitol Hill — and so are ideas for fresh sources of revenue to help pay for them. Among the trial balloons being floated: retirement plans.
Amid concerns that Americans are habitually undersaved for retirement, going after employer-sponsored plans might seem like a nonstarter. Still, the idea of forcing at least some percentage of retirement plan savings into the after-tax Roth option continues to have appeal among some policy makers who tend to see it as a means for the government to tap into current revenue rather than waiting to collect on the back end, when participants retire.
There has been some public pushback to the idea of doing away with the traditional pretax contribution system, which has been a hallmark of defined contribution (DC) plans from the beginning, and replacing it with the after-tax Roth 401(k). The Investment Company Institute, for example, was among those recently objecting to the notion of doing away with pretax savings, noting that their investor research indicates that most people want tax-deferred savings. (Source: Ignites.)
Whether or not the government changes DC retirement savings — or plans continue to have the choice of offering traditional pretax, after-tax Roth, or both — as it turns out, a Roth mandate might not be such a bad idea for many participants, as explored below. Some DC plans have taken the step to offer Roth as an option, often in addition to traditional pretax contributions. Regardless of whether the plan sponsors you work with have considered adding Roth provisions to their plans, the current focus on Roth 401(k)s may provide the opportunity to talk to them about what it could mean for their benefits program and their employees.
The state of the Roth
Enabling retirement plan participants to contribute after-tax income with the expectation of tax-free withdrawals in retirement, some DC plans began adding Roth provisions after passage of the Pension Protection Act of 2006, which made Roth 401(k) regulations permanent. A decade later, 58% of plan sponsors were offering them, mostly in larger plans. While uptake among their participants has continued to trend upwards, by 2016 just 13% of participants with access to Roth 401(k)s had chosen them, with the highest concentration among younger workers.1
Why haven’t greater numbers of plan sponsors and participants embraced the Roth option? For participants, inertia clearly plays a role. Once employees enroll in their plan, they tend to stay put. So anyone who enrolled in a DC plan that had a Roth option added later is most likely still contributing pretax dollars.2
Conversions from a traditional account to a Roth 401(k) for participants in an employer-sponsored plan that offers both features are now permissible under a 2013 law. The tax consequences (the participant must pay taxes on the converted assets for the year the conversion is made) are to be expected, but they may seem daunting to employees and can dampen enthusiasm.
Is a Roth 401(k) worth it for participants?
Some plan sponsors have taken a wait-and-see approach with Roths. Is changing plan design worth the trouble? After all, Roth contributions — and their earnings — must be accounted for separately. That’s because only employee contributions and their earnings may be withdrawn tax-free in retirement. Employer contributions must be made pretax, so they and their associated investment gains are subject to ordinary income tax upon withdrawal.
But such administrative complications are minor because recordkeepers are generally well equipped to handle them, and the associated costs are relatively low. The more significant challenge — and one worth discussing with plan sponsor clients — is participant communications. The different tax treatments of employee and employer contributions must be explained to workers, who also need to understand the pros and cons of pretax and after-tax savings.
Communications should highlight the key differences between the Roth 401(k) and the eponymous Roth IRA, which may be more familiar to employees. Of course, their maximum contribution limits set by the Internal Revenue Service (IRS) are vastly different — just $5,500 for a Roth IRA in 2017 ($6,500 for ages 50 and up), and more than three times that for a Roth 401(k). For 2017, the maximum contribution for a Roth 401(k) is $18,000, and $24,000 for workers age 50 and up.
They also come with different eligibility requirements. While higher-income individuals are not allowed to contribute directly to Roth IRAs, there’s no income litmus test for contributing to a Roth 401(k), making them available to high earners. Plus, while Roth IRAs are not subject to required minimum distributions (RMDs), Roth 401(k)s are. Retirees can easily eliminate this issue by rolling over their Roth 401(k) balances to a Roth IRA.
Could Roth increase the value of the plan?
Considering the potential challenges, should plan sponsors consider allowing Roth contributions? The Roth provision can have significant appeal to key employee groups, including the groups below, which in turn may help attract and retain workers.
- Early-career employees whose current tax bills are low, but expect their incomes to rise as their careers progress.
- Highly compensated employees (HCEs) who are already maxing out their other tax-qualified opportunities and want to accumulate more for retirement by paying taxes on their savings today.
- HCEs who expect to be in a higher tax bracket in retirement or who are constrained by especially low contribution limits because of nondiscrimination issues.
- Well-saved participants nearing retirement who want to limit the amount of their savings subject to RMDs.
- Employees who want to hedge their bets against rising tax rates in the future by taking advantage of tax diversification.
The “Roth effect” on retirement readiness
For plan sponsors seeking to encourage a higher level of retirement readiness among their employees, allowing Roth contributions could be part of the answer. Behavioral science researchers at Harvard Business School have found that participants who choose the Roth option may end up with more purchasing power in retirement. That’s because they tend to save at the same rate whether they make after-tax Roth contributions or pretax traditional contributions.3 Considering that Roth contributions would leave less in their paychecks, why do they do it?
The answer to this head-scratcher seems to be that participants simply follow standard rules of thumb, regardless of the tax implications. For example, they may start by saving enough to get the employer match, and then perhaps increase to the often-suggested 10% of their income later.4
Now may be the time to talk
Regardless of whether any level of Roth contributions ever becomes mandatory, there may be compelling reasons to consider them. If plan sponsors are interested in boosting plan health, keeping their plans competitive, or increasing retirement readiness among their employees, now could be the time for a conversation.
|DC plan contribution systems: Traditional versus Roth
|Contributions made on a pretax basis.
||Contributions made on an after-tax basis
|Withdrawals, usually in retirement, subject to income tax.*
||Withdrawals tax-free after age 59½.**
*With a traditional 401(k), penalty-free distributions may be available as early as age 55. If retirement occurs prior to age 55 or in certain older 401(k) plans, the participant would have to wait until age 59½ to take penalty-free withdrawals; regular income taxation applies regardless.
**With a Roth 401(k), a special five-year rule applies. Tax-free withdrawals depend on whether Roth contributions have been held for a minimum of five years even if the participant is over age 59½.
1Alight Solutions report, Employee Savings and Investing Behaviors in Defined Contribution Plans, 2016.
2Beshears, John, James J. Choi, David Laibson, and Brigitte C. Madrian. "Does Front-Loading Taxation Increase Savings? Evidence from Roth 401(k) Introductions." Journal of Public Economics 151 (July 2017): 84–95.
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