Roth Maximizes Retirement Savings Power for Employees

Interest is growing around this option, and the existence of other after-tax retirement savings vehicles begs the question, why offer Roth accounts? Once familiar with Roth accounts, plan sponsors quickly realize there are many benefits to this DC plan design feature—for both the employer and the employee. 

For one, the adoption of a Roth feature provides employees with the potential to lower taxation in retirement as part of an overall tax diversification strategy. So considerable are the tax benefits that the number of questions about Roth increases around tax season, when accountants ask their clients to consider investing in a Roth to take advantage of the savings. 

Roth vehicles invest after-tax dollars, and enable the investor to enjoy tax-free investment gains when drawing down from the account (subject to a five-year account aging requirement and qualified distributable event). In addition, Roth retirement plan distributions will not trigger taxation of Social Security benefits, and don’t count as income for many other purposes—such as calculation of the new 3.9% Medicare surtax. Plus, employees can still enjoy an employer match on the money invested. (Employer match is invested in a traditional pre-tax account and those assets and their earnings will be taxable upon distribution.) 

Roth accounts can be good for many employees, but they are of particular benefit to younger Americans who are most likely in the lowest tax bracket of their career. Other things equal, the more their earnings, lifestyle, and tax rates rise as they get older, the more they will tend to benefit from using a Roth account. Much of the interest Fidelity receives about Roth 401(k)s comes from employers with a large Millennial employee base who are looking to increase retirement saving power.

Roth accounts are also helpful for high income earners. Because their high earnings exclude them from making Roth IRA contributions, the alternative savings option in a DC-plan Roth account is all the more appealing. For those who are maxing out their DC plans, a Roth 401(k) can in effect allow for a larger contribution. Although the annual contribution limit—$17,500 in 2014—applies to both traditional and Roth contributions, qualified Roth distributions are not taxed, so other things equal a $17,500 Roth contribution would create more spending power in retirement. Additionally, participants older than age 50 can make Roth catch-up contributions to potentially decrease tax liabilities in retirement.

As a result of these multiple advantages, it’s no surprise that overall Roth contributions are on the rise. To date, approximately 44% of Fidelity-recordkept 401(k) plans offer a Roth option compared to 26% three years ago.

Also, recent regulatory changes make it easier to convert existing traditional DC plan balances to a Roth account. Employees are now able to do an “in-plan” Roth conversion. This feature allows employees to convert both vested pre- and post-tax assets into Roth account assets provided the employee pays the taxes due on the converted funds. (Taxes due on converted assets must be made during the plan year in which the conversion takes place.) Policy makers are also increasingly looking at limiting the amount of pre-tax savings and requiring Roth contributions as a way of shifting the stream of tax due on those contributions and as a component of tax reform.

The fact that investing in a Roth account is more accessible is good news because Roth savers tend to invest more for retirement overall. The average employee deferral rate for a traditional 401(k) is 8.0%, while the average deferral rate for those contributing to Roth is 10.7%—consisting of a 6.5% post-tax Roth deferral and a 4.2% pre-tax deferral.

Also, many participants saving in a Roth account (59%) defer additional sources of money, such as pre-tax or after-tax—enabling them to maximize their retirement savings capability.

Roth accounts benefit employers as well. The inclusion of a Roth provision in DC plans allows companies to showcase the value and competitiveness of their overall benefits offering, which can help them attract and retain the best talent. Many employers indicate their employees increasingly view retirement offerings as a benefit that differentiates the company from its hiring competitors. As this shift happens, more emphasis is being placed on offering best-in-class retirement benefits—and a Roth account is one of them.

So how does a company begin offering its employees a Roth account? The best place to start is to get senior management on board. Support from executives will help fuel the conversation about the importance of having the proper tools—like Roth accounts—to save for retirement.

Next, speak with the recordkeeping service and payroll providers. They can help determine what administrative changes may be needed, and talk through any plan amendments or changes required to adopt Roth accounts.

Then, educate the workforce. Offering Roth accounts is an opportunity to open a dialogue with employees so they understand fully how it is different from a traditional account, as well as to showcase the various tools they have at their retirement planning disposal.

The top three considerations that plan sponsors should weigh are:

• Addition of a Roth provision may affect the results of non-discrimination testing;
• The need for plan amendments and changes to the payroll and recordkeeping systems;
• The development of communications campaigns to educate and inform plan participants about the plan design changes. This is especially true in the case of the Roth and in-plan conversion features, where implications may not be well understood.

Overall, Roth accounts are an important tool to help employees better prepare for retirement. With adequate education and preparation, individuals will be provided with the means to achieve better financial outcomes for their retirement.

Donna Norwood, vice president of Workplace Investing at Fidelity Investments, in Smithfield, Rhode Island.  

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.