Are Roths the Future of 401(k)s?

For savers in defined contribution plans, the question of whether to save on a pre-tax or after-tax basis is often boiled down to a simple rule of thumb: If you expect tax exposure to stay level or increase in retirement, then a Roth strategy makes the most sense.

That basic barometer is what makes the Roth option an "undisputed no-brainer" for younger savers on the lower end of the earning curve, said Marina Edwards, a senior consultant to 401(k) plans with Willis Towers Watson.

But Edwards, and her firm, are trumpeting the value of the Roth savings strategy for more savers, particularly in light of the lower marginal tax rates ushered in with the passing of the Tax Cuts and Jobs Act last December.

Under tax reform, most Americans now pay lower marginal rates. But those rates are scheduled to sunset at the end of 2026—meaning most Americans can expect their tax rates to increase in the foreseeable future.

Intentionally or not, the TCJA has made a Roth savings strategy more valuable than traditional pre-tax contributions for most savers, if the increased tax rate barometer is applied.

"Roth has an added bonus with the lower tax rates," said Edwards. "The strategy made sense before tax reform, but it makes even more sense now."

Fiscal conservatives have vowed to make cuts to the individual rates permanent. Some have also speculated that rates would go up were Democrats to take control of Congress and the White House. The prospect of either does not necessarily neuter the value of saving on a Roth basis, says Edwards.

"Creating tax diversification makes sense with or without tax reform's lower marginal rates," she said. "Saving on a Roth basis will still be valuable if the new rates sunset. But with the lower rates, we have a hot iron we need to strike now."

Using after-tax dollars to save in defined contribution plans—Roth deferrals grow tax-free and distributions in retirement are not taxed—provides for natural diversification, notes Edwards. Participants' deferrals are made on an after-tax basis, but employer contributions are made on a pre-tax basis. Saving in a traditional 401(k) platform only allows for pre-tax contributions; withdrawals are taxed at retirees' marginal rates.

"We don't know what tax rates will be in the future," noted Edwards, who said if there is one guarantee to bet on it is that rates will change.

"Who knows what will be concocted? But if I believe I need to hedge my bets with some pre-tax and some after-tax contributions so I can make withdrawals sensibly, then Roth is the option," said Edwards.

Roth lagging, but default could be in the future

Roth utilization in 401(k) and other defined contribution plans lags traditional contributions.

Created by the Economic Growth and Tax Relief Reconciliation Act of 2001, the Roth option was implemented into plans in 2006. Originally scheduled to sunset at the end of 2010, the Pension Protection Act of 2006 made the option permanent.

Adoption has spiked since—a survey of Willis Towers Watson's clients shows 70 percent of plans offer a Roth option. The Plan Sponsor Council of America puts adoption at 63 percent.

But utilization of a Roth option is still modest. Only 18 percent of participants in PSCA's survey made a Roth contribution—in the smallest firms with fewer than 50 participants, rates were the highest at 29 percent. And a scant 4.6 percent of plans offer a Roth-only platform.

That savers are undervaluing the potential advantages of a Roth strategy speaks to the hurdle plan consultants and sponsors have long faced on all aspects of plan design: educating the employee.

"If we've learned anything from the past 20 years working with 401(k) plans, it's that take-up of education on these topics is very slow," said Edwards.

For the average participant, navigating technical questions like optimizing retirement tax strategies is understandably daunting.

Nonetheless, the needle on Roth is moving, thinks Edwards, thanks in large part to recordkeepers' innovations with educational tools for plan participants. WTW partners with recordkeepers to optimize education campaigns.

She expects the evolution of the Roth model to follow the maturity of other plan design features.

"We used to really focus on enrollment, and getting people to participate in plans. Now we just do that automatically. Then we shifted to try to educate on diversifying investments. Now, through target-date funds, we do that automatically," said Edwards.

"The education around Roth has begun. Now what's going to start to happen is we are just going to do it for participants," she added, suggesting the era of automatically enrolling participants into the Roth, rather than traditional model, is foreseeable on the horizon.

WTW is not advocating for a Roth-only world—Edwards says plans should preserve employees' option to choose between Roth and traditional strategies.

And while more employers are seeing the light on the value of Roth, they have legitimate concerns over the energy and investment required to adequately educate employees, particularly on the more complex question of whether savings in traditional 401(k)s should be converted to a Roth plan, which would create tax liabilities.

"But fear should not stop sponsors when we have a tax strategy that can improve your workers' retirement outcomes substantially," said Edwards.

As for the 30 to 40 percent of plans that don't offer a Roth option, there is little reason not to, as most recordkeepers do not charge sponsors or participants a fee when adding a Roth option.

"It doesn't cost them a nickel," said Edwards.

— Related on ThinkAdvisor: