Roth 401(k) – Underrated Beauty?
It’s a classic plot line in literature or movies, and a play on the Cinderella story. The quiet, artistic or perhaps “geeky” character goes unnoticed by their love interest, a popular, beautiful or handsome character.
The main character spends much of the story attempting to make changes to their appearance and social or economic situation to catch the attention of the aforementioned love interest. Usually, by the end of story, the main character comes to the realization that they were good enough all along, and either girl gets boy/boy gets girl, or they move on more self-assured and content.
Roth 401(k) deferrals seem to follow a similar plot line, but our question is why? Time and time again as we talk to new or prospective clients they are surprised to learn that Roth contributions are an option in a 401(k) plan.
Roth deferrals to a 401(k) plan are an attractive option for many individuals interested in retirement savings. 401(k) plans offering Roth deferrals as an option allow participants to choose between a traditional pre-tax 401(k) salary or a Roth salary deferral.
A traditional pre-tax 401(k) deferral withholds the employee’s salary deferral prior to the calculation of federal and state withholding, thereby reducing their taxable wages. If the participant chooses the traditional 401(k) salary deferral and opts to pay less federal and state withholding at the time of the deduction, the deferrals are deposited into the 401(k) plan and grow tax deferred. The participant will then pay taxes on those contributions, and the earnings on the contributions, at the time that he or she retires and takes a distribution.
A Roth salary deferral is deducted after federal and state withholding is calculated on their wages. If the participant chooses the Roth 401(k) salary deferral, he or she will pay state and federal withholding on those deferrals at the time they are withheld. However, when the participant retires and takes a distribution from his or her retirement plan, they will not pay taxes on the earnings on those contributions.
Roth deferrals are undoubtedly beneficial, especially for younger participants who are just starting their careers. Roth deferrals can help protect retirement assets from potential future increases in tax rates. As the participant’s earnings grow, so will their tax rate. Therefore, paying taxes on their deferrals now and allowing those contributions to accumulate earnings on a tax-free basis could reduce their taxes in the future.
Many advisors believe that it is good for investors to have a balance of tax-free accounts and tax-deferred accounts from which to take retirement income.
Eligibility to make Roth contributions to a 401(k) plan is not subject to the same income limitations imposed on the ability to make Roth IRA contributions. Therefore, anyone whose plan allows for this option can make Roth deferrals to a 401(k) plan.
Roth IRAs are not subject to the required minimum distribution (RMD) rules that traditional IRAs and 401(k) plans are subject to. This means even after an account holder reaches age 70.5, he or she is not required to take distributions from the Roth IRA and can allow it to grow tax-free long after that time. In fact, upon their death it can be passed to their beneficiaries. Therefore, if a participant accumulates Roth savings in their 401(k) plan, then rolls those assets out of the 401(k) plan and into a Roth IRA before they attain the age of 70, he or she can avoid the RMDs from their Roth account under the 401(k) plan.
Roth has been around for almost a decade, and yet it continues to go unnoticed by plan sponsors and participants alike. Our conclusion is that Roth has yet to reveal itself as the stunner it is, or the allure has yet to catch on.
A tip to advisors, review the benefits of Roth with your clients and encourage them to include Roth in their 401(k) savings.
A tip to Plan Sponsors, offer a Roth 401(k) option to your employees, and be ready for their questions if they don’t know what Roth contributions are.
A tip to participants, review the Roth option with your tax preparer if it is available in your retirement plan, and consider taking your Plan Sponsor up on their Roth 401(k) offer!
Questions on Roth 401(k) or other retirement plans? Email us or call 405-848-401k.