Myths and misgivings about Roth 401(k) plans can block employees from making valuable decisions about their retirement. Roth 401(k)s can offer many benefits over traditional 401(k) plans, yet few workers make use of this option. Our Retirement Services group data shows that just over half of 401(k) plans offer Roth contributions. Within the plans that offer Roth, only 5.4 percent of participants actually make Roth contributions. In an effort to help our clients better understand Roth 401(k)s and the benefits they offer, we’d like to dispel some of the myths that may be leading to this underutilization.
Some employees falsely believe that the term “Roth” is synonymous with the Roth IRA – and all the rules that come with it, like income-based disqualifiers and low contribution limits. Others don’t realize the level of flexibility Roth 401(k) contributions can give them when it comes time to use the funds for retirement. Let’s look at the differences between a Roth IRA, Roth 401(k), and a traditional 401(k), and then weigh the benefits.
Understanding What Makes a Roth 401(k) Different
Most employees understand how a traditional 401(k) plan works. Pre-tax contributions are made to a retirement savings account which can be invested in a variety of stock and bond funds. The dividends, interest, and capital gains on those funds grow tax-deferred until they are withdrawn, presumably at retirement. The funds are taxed as ordinary income at the time they are withdrawn. This is a good choice, assuming the employee will make less money during retirement and, therefore, pay a lower tax rate on the withdrawals.
It’s important, though, to help employees understand that a Roth 401(k) is not the same as a Roth IRA. The 401(k) is a special retirement plan category and Roth is simply a type of contribution offered in some 401(k) plans. Both pre-tax and Roth 401(k) contributions fall collectively under the annual contribution limits and are not subject to income limitations, allowing even high-earners to make Roth contributions. If the employer offers a match, employees can contribute Roth funds and the employer will match those funds on a pre-tax basis. In this way, employees can hedge their bets by making Roth contributions while having the pre-tax 401(k) funds from the employer available as well.
Another misunderstanding may arise in how withdrawals are taxed. With a traditional 401(k), both the contributions and earnings made from pre-tax contributions are taxed. With a Roth 401(k), both the contributions and the earnings generated from them can be taken tax-free.
Flexibility Benefits of Roth 401(k)s
Roth 401(k)s also offer greater flexibility in control of the funds, allowing employees to pass the account to heirs, suffer fewer taxes and penalties on early withdrawals, and enjoy an early retirement option.
- Legacy Options – Rolled over into a Roth IRA, the employee can name a beneficiary allowing the money in the plan to continue growing tax-free until the beneficiary withdraws the funds. With a 401(k), required minimum distribution rules mean the funds must be distributed within five years of the investor’s death.
- Fewer Penalties for Early Withdrawal – Early withdrawals of contributed funds in a Roth 401(k) are not subject to a penalty, assuming the employee has been using Roth for at least five years. Only gains made on contributions are subject to taxes and penalties if taken prior to age 59 ½. The penalty and taxes are calculated on a prorated basis by looking at the value of the plan compared to the dollars the employee contributed from earnings. Otherwise, the same tax and penalty rules of a traditional 401(k) apply.
- Early Retirement Option – If you retire at age 55 (and are no longer working), you can withdraw the funds without penalty.
So, Who Should Take Advantage of Roth 401(k) Options?
Essentially, anyone who expects to be in a high tax bracket or generate a strong income later in life may benefit from Roth contributions to a 401(k). This includes:
- Employees in Early Stages of Career – This includes young professionals just starting their careers. The likelihood of moving up the ladder and earning more by retirement is high. Paying taxes on contributions now, while their income is much less, may make sense.
- High Earners Not Eligible for Roth IRA Contributions – Income limits applicable to Roth IRAs are non-existent in a 401(k). Roth 401(k) contributions become excellent potential investment vehicles for passing funds to an heir.
Those in the middle stages of their careers will have harder choices to make. The complex nature of taxes means it’s anyone’s guess whether their tax rates will be higher or lower during retirement, making the benefits of Roth contributions less certain.
If your employees remain uncertain about Roth contributions, several online calculators can help them decide how to proceed. The oddly named but excellent calculator at DinkyTown is one good calculator. Several other financial calculators at Schwab can help.
The ABD Team Can Guide Your Employee Retirement Plan
The ABD Team helps employers offer the best employee benefits that fit your company profile. We offer data to help compare and track plans, find the most beneficial employee portfolios, and provide retirement advice to your employees. The ABD Team even advocates for your business to ensure fees remain competitive while acting as co-fiduciary on your account to manage compliance and regulatory requirements. Call us to find out more.