by Lisa Higgins, Contributing Editor
Have you given your employees every opportunity to reach a secure retirement? There is one simple strategy you may not be using that could make a real difference: the Roth account.
According to a survey from Willis Towers Watson, Capturing the Opportunity of Roth 401(k) Contributions, What Employees Are Missing and How Employers Can Help, just over one-half of employers included these after-tax accounts in their 401(k) plans by 2014; the percentage increased from 46% in 2012 to 54% two years later.
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Still, the company calls Roth accounts “woefully underutilized.” Their survey indicated that less than 10% of employees with access to a Roth account in their 401(k) plan currently make use of one.
One reason for the dismal Roth participation rates may be that employees don’t understand how they work, much less how they may be of benefit. This could be because employers aren’t clear on these things, either. For those whose Roth knowledge is a little fuzzy, here’s a primer.
Roth 401(k) account: The basics
Your company 401(k) plan allows employees to save for retirement with before-tax money. In fact, that’s probably the key selling point for turning employees into participants. When added to a traditional 401(k) plan, a Roth account gives employees another way to save—with after-tax money.
While this seems less appealing on the surface, taking a long-term view gives a different picture. When money is withdrawn from a traditional 401(k) account, it is taxable as income at the then-current rates.
Roth money, on the other hand, has already been taxed. The withdrawals, including their investment earnings, come out without income taxes as long as the withdrawals are considered to be qualified distributions.
For employees who expect to be in a lower tax bracket when they withdraw their 401(k) balance in retirement, a traditional account might be a better deal. That’s because they avoid paying taxes at their current (presumably higher) tax rate. Instead, they will pay income taxes on the withdrawals later when they may have only Social Security and the plan withdrawals as reportable income.
In cases where an employee expects either his or her personal income tax rate or the overall tax brackets to be higher when withdrawals begin, a Roth account could be a good choice. This might apply to someone whose retirement income will include sources besides Social Security and plan withdrawals.
For example, someone who expects investment income from outside the plan or from a second-phase job might fall into a higher income tax bracket than during their working years.
How much can employees contribute?
A Roth 401(k) account is subject to the same contribution limits as a traditional 401(k) account. People who are under the age of 50 can contribute up to $18,000 per year to their company 401(k) plan in 2016, whether in a traditional account, a Roth account, or a combination of the two.
For employees age 50 and up, there is an additional $6,000 catch-up contribution allowed in 2016, for a total of $24,000 per year. Of course, there are details you should understand … And so should your recordkeeper.
The decision employees face when deciding where to put their 401(k) contributions is not cut-and-dried. There are details of taxation that come into play, and there may be a little intuition as well. Carrie Schwab-Pomerantz, CFP, President, Charles Schwab Foundation, addressed some concerns in a blog post dated July 23, 2014 (www.schwab.com).
“You’ll often hear that a Roth account, whether an IRA or a 401(k), is best for young investors,” she wrote. “That’s because they are currently in a low income tax bracket, and the up-front tax deduction of a traditional retirement account is less valuable than the tax-free withdrawal of a Roth down the road.
“Lately, however, financial advisers have been pointing their older clients toward Roth accounts as well. Unlike a Roth IRA, there are no income limits on a Roth 401(k), so the door is wide open for older, higher-earning employees to get the benefits of tax-free withdrawals later on.
“The good news is that when it comes to a traditional vs. a Roth 401(k), you don’t necessarily have to make an all-or-nothing choice,” Schwab-Pomerantz continued. “You can have both, and decide year-by-year where you want to make your contributions. If your employer’s plan allows it, you may even be able to split your contributions 50-50 between the two types of accounts.”
Helping employees see the value
Ignoring the Roth account can be a needless barrier to retirement security, according to Willis Towers Watson Senior Retirement Consultant Marina Edwards. “A Roth 401(k) account can be a tremendously valuable vehicle for employees to save for retirement,” she said.
Her colleague, Kevin Wagner, who is also a senior retirement consultant, agrees: “When employees bypass Roth 401(k) contributions, they unnecessarily narrow their tools for tax-effective retirement savings.
“For some,” Wagner continued, “using distributions before age 65 may enable qualification for health care subsidies under the Affordable Care Act.” That’s because the individual’s reportable income is lower when it comes from a Roth account rather than a traditional 401(k) account.
“Roth contributions can also help some retirees avoid the tax torpedo, which can increase a retiree’s marginal tax rate based on the tax phase-in on certain Social Security benefits,” Wagner says.
The Willis Towers Watson study, available for download at http://tinyurl.com/WTW-Roth-Study, suggests employers help their employees understand their Roth option and utilize it more effectively, by:
- Communicating the program’s features and benefits clearly and regularly.The value of a Roth account may change based on an employee’s stage of life or other circumstances. It’s important to segment employees and identify their needs on the basis of characteristics. Some examples are pay levels, marital status, and age. The messages should be tailored with employee needs in mind, and they should be short and action-oriented, according to the firm.
- Using interactivity in communications. Willis Towers Watson says traditional retirement education tools, like newsletters, account statements, and webcasts, can be augmented with mobile apps and digital technologies to capture employee attention and engage them.
- Providing effective modeling strategies.Employees may better understand their options when retirement planning modelers are robust. They should include total estimated retirement income, pay growth, inflation, tax effects, and health care costs, according to Willis Towers Watson.
- Monitoring employee financial well-being.The report suggests a regular process of monitoring employee financial wellness through plan-level analysis focused on when employees will reach retirement readiness.