Expanded Roth Conversion May Boost Adoption Rates

In late 2010, federal tax legislation began to offer another Roth option to certain participants (generally those with certain distributable plan assets), which allowed the participants to convert existing pre-tax balances to Roth savings, according to Vanguard’s paper, “Roth adoption and the new in-plan conversion.” In the January 2013 American Taxpayer Relief Act of 2012 (ATRA), this conversion feature was expanded to all participants, assuming the feature is offered by the plan.

A plan sponsor can now offer a Roth feature allowing participants to convert all plan assets, including employer and employee pre-tax contributions and earnings, to Roth savings. This new provision is effective for conversions made after December 31, 2012.

To offer Roth in-plan conversions, a DC plan must also offer Roth elective deferrals.

To date, Roth features have not been highly utilized. In 2012, half of Vanguard defined contribution (DC) plans offered Roth elective deferrals, and 11% of participants with access to Roth deferrals used this option. Four percent of plans offered Roth in-plan conversions, and less than 1% of participants with access to the option converted assets between 2010 and 2012. These figures are expected to rise as the new conversion option is made available by sponsors, Vanguard’s paper predicts.

“I think eventually, [nearly] all plans will offer Roth, but it’s going to take awhile to get there,” Jean Young, senior research analyst at the Vanguard Center for Retirement Research, told PLANSPONSOR.

Young compared the slow adoption rate of Roth features to the catch-up contribution provision, which took a while to gain momentum. Catch-up contributions allow participants age 50 and older to make additional contributions to their 401(k) and/or individual retirement accounts (IRAs).

Vanguard’s report, “How America Saves 2013,” broke down Roth participation rates by demographics and found participants ages 25 and younger were most likely to use it (18%), compared with 4% of those ages 65 or older.  Between genders, 11% of males used Roth, compared with a close 10% for females. Regarding job tenure, those most likely to use Roth were in a job zero to one year (16%).

Of course, Young pointed out, Roth features are not for everyone. In general, participants who should seriously consider Roth savings are those who are more likely to face a similar or higher tax rate in retirement, Vanguard’s Roth adoption paper said. This includes “strong savers” and those better prepared for retirement; those saving at the maximum 402(g) limit; younger participants facing a low (10% to 15%) marginal tax rate today; and participants who expect to leave their rollover Roth IRA assets as part of their estate.

Roth may not be for those who qualify for certain tax credits—including the earned income and various child and childcare credits, among others; higher-income retirees receiving Social Security; and six-figure-income tax payers.

Young suggested that because Roth is so complicated, those interested in Roth should seek professional tax advice, especially before a conversion. “You can inadvertently throw yourself into a different tax bracket,” she cautioned.