Are You Offering a Roth 401(k) Plan Option Yet?

In a Roth 401(k) plan, participants make after-tax contributions to a qualified plan and obtain tax-free distributions, provided the funds remain in the plan for a period of at least five years from the date of the initial Roth 401(k) plan contribution. Thus, while participants pay a tax on the income that was the origin of the contribution, the earnings on those contributions are tax-free. Is the option of a Roth 401(k) plan suitable for your organization’s qualified plan?

The Roth Option

Roth IRAs have existed since 1997, and Roth 401(k) plans were authorized by the Pension Protection Act of 2006. The ability to convert existing pretax balances within a 401(k) to Roth status was further expanded by the American Taxpayer Relief Act of 2012.

It’s usually easier for participants to begin making after-tax contributions to a Roth account within their 401(k) plan rather than to convert a considerable existing pretax amount to the plan’s Roth component. Why would that be the case? Because, just as it is with an IRA conversion, a Roth 401(k) conversion produces a tax liability that participants then are required pay on the conversion. If they need to use the cash from their retirement funds and they’re younger than age 59½, they’d get to preserve only 90% of the amount after the 10% premature withdrawal penalty was deducted, less whatever amount of  regular income taxes that would be incurred.

Even with this being true, many plan sponsors let participants make that decision for themselves. According to a survey by consulting firm Aon Hewitt, in-plan Roth conversion features are gaining momentum. In 2013, 27% of surveyed sponsors allowed in-plan conversions, and another 66% were likely to add that feature in the near future.

It’s one thing for an organization to offer a Roth 401(k) plan option, but are their participants using it? At the beginning of this year, an average of 11% of employees in the Aon Hewitt survey who had the Roth 401(k) plan option used it. Generally, the longer the Roth 401(k) plan choice exists, the more participants use it. For example, 18% of participants in those plans that had the Roth option for at least seven years took advantage of that opportunity.

The Importance of Age

The participant’s age also factors into the adoption of a Roth 401(k) plan option. For example, more than 17% of twenty-somethings contributed to a Roth last year vs. less than 9% of participants in their 50s. Given that the younger participants will have a longer time period from which to benefit from the buildup of tax-free earnings on their contributions, this makes sense.

They’re also far less likely to be confronted with a big tax hit by converting an existing pretax 401(k) plan balance to a Roth account because their current balances are generally lower. For older participants however, there may not be enough working years remaining in their careers to earn back the money that’s lost to taxes upon the conversion, and they may instead be better off just leaving those assets where they currently are.

Roth 401(k) Plan – An Example

How then can participants conclude whether or not to take advantage of the Roth 401(k) feature? Let’s assume that a participant’s tax rate (25% in this example) will not change. If he or she then contributes $5,000 annually to a Roth 401(k) plan, earning 7%, after 30 years the total accumulation will be about $505,000. This entire amount will be tax-free upon withdrawal. If instead the contributions accumulate in a regular pretax 401(k) account, only about $380,000 will be left after taxes upon withdrawal.

However, a participant who contributes $5,000 each year in the Roth 401(k) plan will actually be required to pay $1,250 (25%) in taxes each year on that $5,000. So if the Roth  participant actually contributes only $3,750 to the Roth annually (the amount left over after taking out the 25% in taxes), the total accumulation will be the same ($380,000) as would remain after taxes on the $505,000 as noted above.

Of course, it’s likely that the participant’s contributions will increase over time. Also, this simplified example doesn’t take into account any employer contributions to the plan. Finally, there’s no way of knowing the tax rates the participant will be subject to throughout their retirement. If they’re higher, the Roth 401(k) plan after-tax contributions would put the participant ahead of the game. In the unlikely event that the participant’s tax rate will be lower in retirement (which used to be the case in the past, but now seems less likely to be the truth), the opposite would then be the case. Given that uncertainty, participants may choose instead to break up their deferrals between both the Roth and the pretax options in their 401(k) plan.

Making the Roth 401(k) Option a Reality

Giving 401(k) plan participants the choice to open up a Roth account within a 401(k) plan — either by starting a new account or by converting some or all of an existing account balance into the Roth structure — may soon become the standard, predicts Aon Hewitt. Half of the plan sponsors in its database (which are primarily larger companies) already have the Roth option. Giving your employees the chance to participate in a Roth 401(k) plan may assist them in hedging their bets about the income tax environment that will exist in their retirement.

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