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Roth: Breaking Down the Buzzword in Defined Contribution Plans

While many know the moniker, we often find that many participants in Defined Contribution plans do not know the assorted differences between your Traditional or “Pre-Tax” and Roth 401(k). Many participants (and even plan sponsors) are also not aware of some of the unique similarities and differences between Roth when offered in a Defined Contribution Plan versus an Individual Retirement Account (IRA). Our objective is to provide a general overview of Roth, its role and appeal within Defined Contribution Plans, and finally, key considerations for plan sponsors in
evaluating this feature in an educated and informed manner.

Please Note: Our references throughout to “Plan” or “DC Plans” will primarily focus on the 401(k) Plan, although we will note that many (but not all) of the same assumptions will largely apply to 403(b) and Governmental 457(b) plans throughout this paper as well.

Roth: A History Lesson

The “Buzzword” came into existence after the creation of a new After-Tax Individual Retirement Account (IRA) as part of the Taxpayer Relief Act of 1998. The “Roth” term used today comes from the chief proponent of the bill, Senator William Roth of Delaware. The TRA of 1998 allowed After-Tax contributions to IRA’s up to a specified limit, along with “catch-up” contributions for those over the age of 50. The bill also specified a limit on those who could contribute, up to a specified Adjustable Gross Income (AGI) Limit.

Roth Contributions came to fruition within DC Plans beginning in January 2006 to allow After-Tax Roth Contributions for 401(k) and 403(b) Plans (Note: Governmental 457 Plans added these contributions in 2011). In 2010, the Small Business Jobs Act (SBJA) permitted “In-Plan Conversions” of Pre-Tax Defined Contribution Plan Account Amounts to Roth, assuming the amount was “eligible for distribution” or “subject to a distributable event” (ex: death, disability, age 59 ½). More recently, as part of the American Taxpayer Relief Act (ATRA) passed in early 2013, In-Plan Roth Conversion Capabilities were amended to allow amounts to be converted to Roth without the existence of an eligible distribution/distributable event.

Roth: What is it?

Roth is an After-Tax Feature for Employee Contributions. Traditionally, Defined Contribution Plans have offered employees the benefit of Pre-Tax Contributions to their Employer-Sponsored Plan, exchanging a deferral of taxation on contributions and earnings NOW until the money is withdrawn from the Plan LATER. This results in a lower taxable gross income for the participant in the near term, as contributions may be deducted from the employee’s taxable gross income. In the future, monies are eventually withdrawn, and as Uncle Sam has yet to receive his tax, the participant pays tax on the amount contributed to the account as well as investment earnings within the account at the applicable federal income tax rates at that time (Please note: certain state taxes may be applicable).

Roth Contributions change the respective “timing” of the key event in this equation of the employee’s contributions/distributions: Taxation. Roth is an “After-Tax” provision (Not to be confused with After-Tax Contribution Features offered prior to Roth’s creation, which are wholly different, but still present in some plans). When a participant contributes to the Roth Contribution Source within their Defined Contribution Plan, their contributions are immediately taxed at today’s respective tax rates and contributions are included within the participant’s Adjustable Gross Income (AGI) (or “Taxable Income”). However, down the road, all Roth contributions and investment earnings are tax-free upon distribution (assuming a number of requirements, including a 5-year holding period are met). Therefore, Roth offers immediate taxation on contributions today, in exchange for potentially tax-free income in retirement (again respective state taxes may apply). Figure 1 on the flowing page provides a basic comparison between some key characteristics of Pre-Tax 401(k) vs. Roth 401(k) vs. Roth IRA.

Figure 1: Pre-Tax vs. Roth Vehicles

Traditional Pre-Tax 401(k)
Contributions
Roth 401(k) Contributions Roth IRA*
Contributions are Pre-Tax; Taxation deferred until Withdrawal Contributions are After-Tax; Taxed at Current Rate Contributions are After-Tax; Taxed at Current Rate
Contributions may be Deducted from Taxable Income Contributions Non-Deductible Contributions Non-Deductible
No Income Limits to Participate** No Income Limits to Participate
(unlike Roth IRA)**
Income Limitations based on
Modified AGI Limits
$18,000 Aggregate Individual Contribution Limit
(All Sources)
$18,000 Aggregate Individual Contribution Limit
(All Sources)
$5,500 Individual Contribution Limit
$6,000 Catch Up (age 50+) $6,000 Catch Up (age 50+) $1,000 Catch Up (Age 50+)
Upon Withdrawal: Principal, Interest, Capital Gains Taxed at Ordinary Income Tax Rate Upon Withdrawal: Amounts Withdrawn may be Tax Free
(assuming 5-year holding period and
qualifying conditions)
Upon Withdrawal: Amounts
Withdrawn may be Tax Free
(assuming conditions met)
No Qualified Withdrawal for 1st time Home Purchase No Qualified Withdrawal for 1st time Home
Purchase
Qualified Withdrawal for First Time Home Purchase
Required Minimum Distributions at age 70½ Required Minimum Distributions at age 70½ No RMD’s Required

Primary Source: Internal Revenue Service, www.irs.gov.

Pre-Tax or Roth: Which is Better?

Now that we understand the basic differences between Pre-Tax and Roth within DC Plans, the obvious next question we typically hear is “Which is better?” Despite the varying opinions present among financial planners, the financial press, and industry pundits, there is no right or wrong answer to this question.

This is due to the fact that this is an inherently personal, case-specific consideration for each and every participant that affects the practicality of Pre-Tax, Roth or a combination thereof. While conventional wisdom in the financial press  often notes that generally speaking, younger employees stand to benefit the most from Roth (assumingly earning less now than in their later working years where earnings potential and tax bracket would assumingly be higher), while older employees tend to benefit less (assumingly in a higher tax bracket, shorter time horizon until retirement), we would advocate that this decision should not be viewed in a vacuum by participants. By that we mean the decision should take into account the entire financial planning picture; as participants should closely consider the integration of any Employer Contributions (Remember: All Employer Contributions are Pre-Tax; Roth applies to Employee Deferrals Only), Tax Deductions, expected Social Security Benefits/Inheritances, and respective assets outside their retirement plan when evaluating their overall personal situation in a holistic fashion.

Key considerations for participants on an individual basis include, but are not limited to:

  • Individual Tax Situation
    • Personal circumstances that may affect tax bracket/AGI
  • The Impact of Tax Deductions
    • Impact of Roth/Pre-Tax Contributions on AGI/potential to move to new tax bracket
    • Impact of contribution type on other potential available tax deductions
      • ex: Earned Income Credit, Child/Dependent Credit, Retirement Savings Credit, Adoption Credit, other Itemized Deductions
  • Future Tax Rates – Naturally Uncertain
    • Will participant be in a higher or lower tax bracket in retirement?
    • Will tax rates be higher or lower in the future?
    • Any expected near-term/future events or amounts that may affect AGI/tax rate (i.e. Social Security, Inheritance)?
  • Overall Tax Diversification – Taxable vs. Tax-Free
    • Consider among Various Retirement Sources
      • (401(k), IRA, Annuities, Insurance, Trust Accounts, Inheritances, Illiquid Assets, etc.)
    • As well as within the DC Plan’s Different “Sources”
      • (Employee Deferrals vs. Employer Pre-Tax Contributions – i.e. Match, Profit Sharing, Discretionary Contributions).

Why has Roth Become Popular?

In PEI’s experience, Roth has been a common topic Investment Committees have been discussing and considering over the last few years. From a plan perspective, addition of this plan feature has been driven by both plan sponsor interest as well as the increasingly growing consideration in the marketplace of Roth as a best practice feature within DC Plans.

While statistics can vary widely depending on source, PEI sees more and more plans adding the feature despite relatively static utilization. Vanguard notes that 52% of Plans1 (versus 24% in 2007)2 for which they provide recordkeeping offer Roth to their participants, while Fidelity reports 44% (versus 21% in 2009)3 offering the feature. Similarly, the Plan Sponsor Council of America (PSCA) notes 51% of the Large Plans (5,000+ participants) they surveyed offer Roth as of year-end 2012, eclipsing the 50% mark for the first time. In terms of utilization, Vanguard reports around 13% of participants using the feature, while the PSCA Survey reports 11.8% of participants in plans with 1,000-4,999 employees and 15.1% of participants in Plans with 5,000+ participants4. While utilization (depending on source) has hovered anywhere between 6-15% over the last five years, the addition of this feature to more and more Plans leads PEI to expect a gradual, albeit slow increase in future utilization.

From a participant perspective, while interest has increased across the board, PEI has seen Roth gain the most interest and utilization among younger participants. More anecdotally, in addition to younger participants, PEI has even seen some topical interest (albeit with less uptake) among what could be deemed “mid-career” employees; as well as among some highly compensated employees (HCE’s).

Conjecture of future tax rates aside, in a progressive tax system, primary interest in Roth is prevalent among younger employees. This is driven by the broad assumption that, as most of these employees are earning less during their early working years than at an older age/in their later working years, the appeal to pay taxes now for potentially tax-free distributions later makes sense to many. However, as we know, these assumptions are no panacea, as each participant’s personal circumstances can greatly influence the appeal/practicality of Roth Contributions. Nonetheless, numerous surveys and studies have indicated the largest utilization of Roth among younger participants, especially among what is commonly known as “Generation Y” (generally born between 1979 and 1991).

PEI has also seen modest interest among “mid-career” employees who may be in their 30’s or even 40’s; who are considering the potential appeal of tax diversification given their personal circumstances and a relatively “moderate” horizon until retirement. Typically very in-depth personal considerations arise among this group, given the complicating factors to consider, including potentially more tax deductions available due to common life events (children, home,
college savers’ credit, etc.).

Minor interest among Highly Compensated Employees seems highly counter intuitive in a progressive tax system (“why pay tax now while in a high tax bracket?!”). However, in PEI’s experience, we have seen some interest in Roth among this group, aligning with the more general attractive aspect of this feature: Tax Diversification. Many of these employees have sizable Pre-Tax Account Balances due to their relatively higher salaries and potentially longer working tenures. Hence Tax Diversification to soften their tax bill in later years may make sense given their situation. Couple this with the fact that HCE’s often cannot contribute to a Roth IRA due to AGI Limits for these vehicles, and the appeal for tax
diversification through the 401(k) may make even more sense.

Group observations aside, in recent years PEI has continued to hear more and more frequently from our clients that their participants continue to ask about Roth as it becomes more commonplace in the industry.

Plan Sponsors: Considerations Moving Forward

Despite relatively low participant utilization, we expect gradual continued consideration of Roth among participants who are typically more engaged from a retirement planning/tax perspective, and perhaps more notably – the continued addition of the Roth feature at the Plan level by sponsors who more frequently are considering Roth a best practice feature within DC Plans.

PEI advises the following critical points for Plan Sponsors when considering Roth (Contributions and/or In-Plan Conversions):

  • Couple Roth implementation with a strong participant education and communication program
  • For anything beyond proactive education/communication, ALWAYS recommend participants consider consulting with a tax professional and/or estate planner for their personal situation(s).
  • Consult with your vendor and/or legal counsel for any/all substantive changes or amendments to the Plan
    • This includes the Plan Document, Summary Plan Description (SPD), Communication Materials, etc.
  • History has shown PEI that close client coordination between the vendor, consultant, legal counsel, and any other respective impacted parties is optimal.
  • Our experience has shown us that this coordination, as well as an intelligent, thoughtful, and prepared
    implementation process has been integral in effectively rolling out this plan feature as an added benefit for plan participants.

*Roth IRAs are subject to income limits for both single and married tax filers; whether filing jointly or separately.
**Please note that IRC 401(a)(17) Annual Maximum Compensation Limit may apply.
Note: Contribution and Catch Up Contribution Limits shown reflect 2015 IRS Section 415 Limits.

[1] Vanguard Group, 2014. “How America Saves, 2014: A report on Vanguard 2013 defined contribution plan data.”
[2] Vanguard Group, May 2013.“Roth adoption and the new in-plan conversion feature.”
[3] Fidelity Investments, 2014.“7 Hot Retirement Trends in 2014.”
[4] Plan Sponsor Council of America, 2013. “56th Annual Survey: PSCA’s Annual Survey of Profit Sharing and 401(k) Plans.”