Certain participant conditions and demographics favor a Roth 401k over a pretax (traditional) 401k.
“It’s really to the benefit of people who are in lower-income brackets to take advantage of the Roth, and people perhaps in the higher brackets to take advantage of pretax contributions,” Matt Sommer, Head of Janus Henderson Investors Defined Contribution and Wealth Advisor Services Team, said recently.
The obvious first step is for a 401K plan to adopt the Roth, and more plans are doing so, he added, but not all plans yet offer one. However, recent research indicates that among those who do, participants’ adoption rate is low.
Sommer had some thoughts.
“One is that, perhaps, this is an opportunity for plans who offer both pretax and Roth to pull data from their record keepers,” he explained. “They can get a sense of people below an annual income of, say, $50,000 in the age group of 25 to 35. Those who are just starting in their careers would benefit from a Roth. What sort of employee breakdown between Roth and pretax is there so that they can get a sense where to calibrate their education efforts?”
He added that Janus Henderson noticed beyond that the vast majority of plans who auto-enroll their employees do so into pretax. If a plan sponsor enrolls all employees into a pretax account, those that are 25-, 40-, and 55-year-olds regardless of age, salary, and other factors, why not bifurcate the auto-enrollment between Roth and pretax?
“In other words, for people under 40 or perhaps who make less than $50,000, why not auto-enroll them into the Roth?” Sommer argued. “For people who are a bit older or more highly-compensated and benefit from the pretax contribution, why not enroll them into the pretax bucket? Of course, people can opt-out and always change their minds, but at least you put people on the right course based upon some very simple factors that may be in their best interest.”
The higher tax bracket argument
He also noted that higher-income people, especially those high state and federal income tax brackets, are reluctant to take advantage of Roth because they rightfully don’t want to forgo the deduction.
Yet Sommer suggested that many older, more highly compensated professionals have probably amassed a significant amount in a pretax account and might consider at least somewhat funding a Roth.
“And yes, I understand they don’t get the tax deduction, but of course, that money is going to come out tax-free,” he said. “It’s tough to know which is best because no one knows for sure what tax brackets are going to be when they ultimately pull the money out 10, 15, or 20 years from now. It allows you to hedge your bets and provides a little tax diversification.”
At this point, it’s getting plan sponsors comfortable with that concept as more and more implement Roths, Sommer concluded.
“It’s also a matter of making sure that the service providers have the technology that’s necessary to accommodate that type of plan design.”