As the House and Senate feverishly work to reconcile the differences between their two tax bills, it’s still anybody’s guess what a final bill will look like—and whether President Trump will even sign it into law before Christmas.
But the immediate and resounding outcry against mandating all—or a portion—of 401k contributions be directed to after-tax Roth accounts were welcome to those of us who work to preserve the benefits of employer-provided 401k plans and help workers pursue a secure retirement.
Of course, there is no way of knowing how workers would actually behave if the ability to contribute to their 401k plan with pre-tax dollars was eliminated or curtailed. Results from employer surveys forecasting a decline in participation were worrisome—and ditto research findings on the role of tax savings as a factor in motivating people to increase their retirement plan contributions.
Automatic enrollment of employees into 401k plans has been extraordinarily effective in increasing participation rates, and my own “what-if-Roth” speculation goes like this:
- More than half of 401k plans have a Roth account feature.
- About 13 percent of participants make Roth contributions.
- How many plan fiduciaries will feel comfortable defaulting participants into an after-tax account that so few have elected on their own?
Thankfully, this appears to be a worry for another day. And besides, I come to praise—not bury—Roth.
That’s right—the tax reform drama has drawn attention away from the very real tax benefits and flexibility of after-tax Roth accounts.
The Potential Benefits of After-Tax Roth Accounts
Workers make Roth contributions with after-tax dollars, so those that are counting on tax savings to fund a portion of their plan contributions may reconsider their participation, understandably if they are financially stretched and loathe to see their take-home pay reduced. And a choice—rather than a mandate—allows all of us to determine the best tax-savings strategy for our individual needs.
Yet consider how Roth accounts may be particularly well-suited for younger plan participants, who can benefit from decades-long potential tax-free growth of investment earnings. Plus, early-career workers are likely to be in a lower tax bracket now, when their contributions are taxed, than they will be years from now, when they stand to benefit from tax-free distributions of accumulated savings plus earnings.
Even older and higher-paid workers can leverage the benefits of Roth accounts. Having a mix of taxable and tax-free accounts provides tax-planning flexibility. Need to keep your income below a certain level, maybe to avoid taxes on Social Security benefits? Withdraw from taxable accounts and tax-deferred retirement plans up to the permissible threshold, then get to your income target with tax-free Roth distributions. And with no Required Minimum Distributions from Roth accounts, your distribution timetable is your own, not the IRS’s.
Evidence suggests that retirement savers are motivated when their accumulated savings are expressed as a monthly income payment at retirement, yet few probably realize that as much as a third, or even more, may need to be set aside for taxes. That smarts; Roth distributions soften the blow.
Roth accounts are not for everyone, and I believe that a choice is in order. But as we advocate to preserve pre-tax 401k contributions, let’s not lose sight of the significant potential tax advantages of the Roth choice.
Kathleen Beichert is Head of Retirement with OppenheimerFunds.