Roth 401(k) Isn’t News

According to PSCA’s 61st Annual Survey, Roth 401(k) provisions are now as commonplace as automatic features¹ - so much so that neither was a presentation topic at the PSCA 2019 National Conference.

A Saturday or two ago, I was struck by the matter-of-fact nature of a Wall Street Journal, “When to Save for Retirement in a Roth 401(k).”² Roth 401(k) was added to the tax code in 2001, available January 1, 2006. Initially, it was a temporary feature – set to expire December 31, 2010. The Pension Protection Act of 2006 (PPA) made it indefinite (no tax code preference is ever truly “permanent”).³

In early 2000’s discussions, some service providers resisted adding Roth. In 2001, in my last plan sponsor role, I surprised my service provider by demanding Roth 401(k) be added when first available. I set that expectation and we added that feature January 1, 2006. Personally, as I already had a lifetime of savings on a tax deferred basis, every contribution I’ve made since then has been on a Roth basis.

In 2006, before PPA became law, my service provider and benefits staff were shocked when I proposed adding automatic features using Roth 401(k) as the default. Workers who were not saving tended to be lower paid (in low marginal income tax brackets). They tended to be younger with less service (and more likely to separate prior to retirement). So, if automatic features succeeded in changing their financial behavior to become savers, Roth was likely the better choice for two reasons:

• If they cashed out prior to retirement, Roth contributions would avoid penalty taxes, and 
• If they didn’t cash out prior to retirement, their current marginal tax rates may be the lowest they would see for the rest of their lives – including retirement. 

My staff responded, ‘but no one defaults to Roth when implementing automatic enrollment!’ Of course, I responded ‘that’s no surprise since Roth only became available in the last few months”. I lost the argument. Hindsight tells me that I should have fought harder.

Laura Saunders notes in her WSJ article the following features participants should consider:

• Maxing out contributions on a Roth basis allows individuals to save more. 
• Savers who expect higher marginal rates at payout (federal and state) may want to use Roth. 
• A worker whose federal marginal income tax rate is 12% will likely have a higher rate in retirement. 
• It’s not an either/or choice – most plans allow both at the same time. 
• Roth may be a better source of monies where needed as emergency funds. 

Here are some other reasons to add to Laura’s list – participants might choose Roth 401(k) because:

• Unlike Roth IRAs, Roth 401(k) contributions are not subject to income limits. 
• Roth 401(k) offers a form of longevity insurance if rolled over to a Deemed Roth IRA or Roth IRA. 
• Roth 401(k) creates an exceptional option for individuals who want to create a financial legacy. 
• Roth 401(k) may be effective at avoiding or reducing income related costs applied to entitlements:
  o Taxation of Social Security benefits, and
  o Medicare Part B & D Income Related Monthly Adjustment Amount contributions. 
• Roth 401(k) can be a tax-effective option for funding one-time significant expenses – such as post-employment medical or long term care expenses. 
• Roth 401(k) can fund college costs without adding to income for financial aid scoring purposes. 

Finally, a participant gains even more flexibility to tax-efficiently time Roth contributions where a plan offers in-plan conversion provisions. Roth conversions may be advisable where there is a non-taxable basis in the plan (after-tax contributions), when participants pay taxes with monies from taxable accounts or for those who elect a “back-door” Roth conversion.⁴

When deciding between Roth or pre-tax 401(k), individual participants should consult their tax advisor – not only whether to elect Roth, but when to make that election.

As a plan sponsor, the debate about whether to give your participants the choice of Roth is all but over. Some of your participants will benefit from access to Roth 401(k). And, if you are adding Roth features (or if you previously added Roth 401(k) contribution capability), you may also want to add after-tax contribution functionality (as a mega “catch-up” provision) and in-plan Roth conversion provisions.

Finally, because there is a five-year qualification period to obtain the tax preferences on earnings on Roth contributions, the time to act is now. So, don’t wait. And, remember to prompt participants to consider Roth 401(k) once it becomes available.

¹J. Towarnicky, Are You Still Avoiding Roth!?, 2/21/19, Accessed 5/19/19 at: https://www.psca.org/blog_2018_jack_10 See also: J. Towarnicky, Are You Still Avoiding Automatic Features!? 3/12/19, Accessed 5/19/19 at: https://www.psca.org/blog_jack_2019_16
²L. Saunders, When to Save for Retirement in a Roth 401k), Many workers now have the opportunity to contribute to a Roth plan alongside a traditional 401(k). But lots of people who would benefit from picking that option aren’t doing so, 5/17/19, Accessed 5/19/18 at: https://www.wsj.com/articles/when-to-save-for-retirement-in-a-roth-401-k...
³J. Towarnicky, Roth Celebrates Its 20th Anniversary, How did we get here? Where are we now? 2/27/18, Accessed 5/19/19 at: https://www.psca.org/blog_jack_2018_9 ; See also: J. Towarnicky, Roth Will Be 21 Years Old Next Year, What should a plan sponsor do now that Roth provisions are likely here to stay?! 3/6/18, Accessed 5/19/91 at: https://www.psca.org/blog_jack_2018_11
⁴J. Dickson, M. Bruno, B. Wong, A “BETR” approach to Roth conversions, Vanguard, 2018, Accessed 5/20/19 at: https://personal.vanguard.com/pdf/ISGBETR.pdf