The Rising Tide of the Roth 401k

Many employer-sponsored retirement plan participants are conflicted in deciding which type of account is best for their 401k contributions: traditional or Roth?

Often having no idea which is best for their situation, they need the help of an advisor. You can advise them with confidence if you know just two things:

1) Will they be in a higher or lower tax bracket in retirement?

2) Will tax rates increase, stay the same or decrease in the future?

Know for sure the answers to these questions? That’s great!

• If the participant will be in a lower tax bracket in retirement, most advisors recommend the traditional 401k to receive the benefits of pre-tax contributions now.
• If the participant will be in the same or even a higher tax bracket in retirement, recommend the Roth 401k and pay no taxes on withdrawals in retirement.
• If you know for sure that tax brackets will increase in the future, steer them to the Roth 401k and let those post-tax contributions grow and be withdrawn with no (higher) taxes later.
• If you know tax rates in the future will dip even lower, recommend that traditional 401k and pay lower taxes later upon withdrawal.

Yes, of course, this is terribly oversimplified, but then again, who knows future participant tax brackets or future U.S. tax rates for certain? This being the case—with many advisors saying the goal when making contributions to retirement accounts is to avoid paying taxes when your tax rate is at its highest—it gets quite a bit more difficult to guide that participant to the best eventual outcome.

You may remember the 2017 Tax Cuts and Jobs Act, the first major overhaul to the tax code in three decades, reduced income tax rates for individuals to near-historical lows. Yet due to a quirk in that law, income tax rates for individuals are scheduled to increase to pre-TCJA levels beginning in 2026, unless Congress extends them—which many tax experts view as unlikely.

As the percentage of companies offering a Roth 401k option alongside a traditional plan has grown steadily in recent years, advisors are increasingly being asked to help participants decide whether to stay traditional, opt for the Roth 401k, or contribute to both types as part of a tax diversification strategy.

There are cases to be made for all of these options in certain situations, but it should be noted that the chorus of Roth 401k supporters has grown noticeably louder in recent years, and Roth 401k adoption rates have risen right alongside them.

The Plan Sponsor Council of America’s 62nd Annual Survey of Profit-Sharing and 401k Plans, released in December 2019, showed that nearly a quarter of participants (23%) elected to contribute to a Roth in 2018 when given the opportunity, up from 19.5% in 2017 and 18.1% in 2016.

The Callan 2020 Defined Contribution Trends survey of large employers shows the prevalence of Roth accounts in defined contribution plans has increased from 61.6% in 2015 to 87.1% in 2019.

@401klady a big believer in roth

One of the retirement industry’s most vocal proponents of the Roth 401k is Jeanne J. Fisher, CFP(R), CPFA, MBA, (Twitter handle @401klady), managing director at Strategic Retirement Partners in Nashville and a regular speaker on the 401k-conference circuit.

She says participants who are focused solely on tax rates today versus tax rates in the future are completely missing the point that all of the growth in the Roth 401k is tax-free while with a traditional 401k the contribution and the growth are taxable.

“We all know the value of compounding interest, yet we ignore its value when having this conversation,” Fisher says. “Take a 35-year-old. They can save $10,000 for 30 years, and by the time they are 65 they will have saved $300,000. But with reasonable market growth that account is more like $1 million! I would much rather pay tax on $300,000 than $1 million. It’s why we advocate so strongly for the Roth for younger clients who have a lot of time for the account to grow.”

Her rule of thumb is that anyone with more than 20 years to retirement should heavily consider the Roth, as should lower-income earners.

“If they are in a very low effective federal tax rate, or even a negative tax rate, the Roth is very beneficial. Finally, it can be used as a flexible bucket in retirement for high-income, high-net-worth clients,” Fisher says. “We consider all things like: How is the rest of the nest egg saved? Is it all tax-deferred? Are they expecting a pension? Do they need all of their retirement savings or do they intend to pass it to the next generation? Will they need all of their projected RMDs? I’m not exaggerating when I say—especially particular to the 401k—that eight out of 10 times I will recommend a Roth contribution.”

Education an obstacle to greater

Adoption Fisher notes that educating participants about the advantages of a Roth 401k is one of the biggest challenges to higher Roth adoption rates. Since she experiences a lot of success in getting participants to go the Roth route, how does she go about it?

For one, by providing her previously mentioned talking points with scenarios.

“We illustrate the total growth of the portfolio and what the cumulative account balance could be in retirement,” she says. “We also educate to how it affects their paycheck. Electing the Roth in the 401k isn’t going to result in a big tax bill when you file your taxes. Instead, the tax withholdings are adjusted on your paycheck, and in most cases, you are seeing only a minor adjustment each pay period.”

But after advocating for the Roth for a decade now, Fisher says there are some arguments she still has trouble getting people to see.

First, “many naysayers will argue that the traditional IRA is better because you can then invest the tax deduction and have it grow also.

This argument is wrong because it wholly ignores behavioral finance,” she says. “For one, investors always decide how much they want to save first, and then we talk about taxes. I have never, in my 12-year career, had someone walk back in my office with their ‘tax savings’ and ask to invest it. It just doesn’t happen. Also, most people max out the IRA contributions, which completely negates the argument.”

She notes this is even more profound in the 401k.

“When you elect your deferral online it comes off your gross paycheck. If you elect 10% savings on a $1,000 paycheck, you are contributing $100 into the Roth or $100 into the tax-deferred. Again, the contribution dollar amount is not affected by the tax election. The withholding on your paycheck is.”

Fisher acknowledges that lawmakers could change the rules for retirement accounts, but notes that historically when the government does this, they “grandfather in” existing accounts.

“I believe wholeheartedly they will see all of the accumulated assets that are tax-free and try to change it,” she says. “But I believe they will change the Roth taxation for future accounts, not existing money.”

And arguing tax rates today versus tax rates tomorrow?

“Personally, I think it’s a totally irrelevant argument for someone with 20-plus years of potential account growth. However, if we have to tee up this argument then I would point to all of the nation’s debt, including our recent stimulus package. I can’t imagine tax rates not increasing over time.”

She’s far from alone, with high-profile (and controversial) financial personalities like Suze Orman saying much of the same.

“Please, if you have the ability to do a Roth 401k, 403(b), or a TSP, or a Roth IRA, those are the type of retirement accounts that you want to be in. Stay away from the traditional ones …where you get a tax write-off today but in the long run when you go to take your money out, you’re going to have to pay taxes on it,” she recently told the Pivot Podcast.

Contributing to both

There is nothing stopping a defined contribution plan participant from relying on both a traditional and Roth 401k for retirement. In fact, it is often a good call for those participants who are in a position to do so.

Employers who offer Roth 401k in addition to traditional 401k plans are required to create separate accounts for participants’ Roth 401k contributions and investments. That means the money in a traditional 401k account cannot be “mingled” with the money in a Roth 401k account.

As a result, account statements reflect the status of each individual account.

While any employer matching contributions must go into a traditional 401k account, the employee’s contributions can be split between the two in any proportion desired up to the annual contribution limits in effect at the time for a 401k plan ($19,500 in 2020 or $26,000 for those 50 or older).

If the best plan for a participant depends on what their tax rate will be during retirement—and as previously mentioned we don’t know what that tax rate will be—investing in both types of plans hedges against the possibility they put all their 401k contributions into the one that turns out to be the second-best choice.

Some advisors recommend participants utilize a Roth 401k early in their career (assuming they earn less at that point) and then switch to a traditional 401k later as earnings increase. This strategy is designed to avoid the highest tax brackets in the highest-earning years.

Contributing in some form to both can provide more flexibility than using either account by itself.

Roth boost from SECURE Act?

When the SECURE Act, passed in late 2019, eliminated the “Stretch IRA” that had allowed beneficiaries to gradually take distributions from inherited IRAs over the course of their lifetime, it might have triggered increased interest in Roth 401ks.

“Absolutely,” Fisher says when asked if this is the case. “Especially for high-net-worth clients looking to transfer their estate.

A lot of clients have no intention of spending down all their assets. I expect a boom of high-net-worth clients converting IRAs to Roth IRAs.”

Post-SECURE Act, most non-spouse beneficiaries must take Roth IRA distributions within 10 years, which can lead to higher tax consequences in a short time frame (a parent leaving an IRA with a hefty balance to an adult child could create a big tax hit, as distributions from the inherited IRA are taxed as income).

Roth 401ks have the same 10-year distribution limit for beneficiaries, but they have the potential benefit of reducing tax liability as Roth 401k distributions are not taxed like traditional 401k or IRA distributions (although they do count as income).

Brian Anderson is the managing editor of 401(k) Specialist.