Updated in January 2012
Starting in January 2006, employers were able to add Roth 401(k) plans as an employee benefit. To answer questions from employees—and from management—about the advantages Roth 401(k)s may provide, weighed against factors such as added cost and complexity, HR professionals must have a basic understanding of how these plans work.
Briefly stated, this investment vehicle has attributes of both Roth individual retirement accounts (IRAs) and traditional 401(k)s. But unlike traditional 401(k) plans, where employees make pre-tax contributions and, after retirement, pay income taxes on all distributions, Roth 401(k) contributions are made with after-tax dollars. Funds in the plan grow tax-free, and on retirement no taxes are owed on any distributions.
And unlike Roth IRAs, which in 2012 limit contributions for high-earners with adjusted gross income (AGI) at or above $125,000 for singles (or $173,000 for married couples), Roth 401(k)s aren't subject to AGI limits. In 2012, an employee at any income level can contribute up to $17,000 ($22,500 if age 50 or older) to either a Roth 401(k) or a traditional 401(k) but not both, or make a combination of Roth and traditional contributions within these limits.
But how should an employer decide whether to add this option to its benefits mix?
One factor is the composition of your workforce (age, pay levels, sophistication). Another factor is the likely "push" from employees.
In particular, younger, well-paid employees may benefit from a Roth 401(k) since their contributions would be taxed now, when they are in a lower tax bracket, rather than years down the road, when they are likely to be taxed at a higher rate due to increased income. Their earnings on many years of contributions, including capital gains appreciation and reinvested dividends, will never be taxed.
Roth 401(k)s may also offer advantages for older employees. Under a traditional 401(k) plan or a traditional individual retirement account (IRA), if a person reaches age 70 and is no longer working, he or she must start taking required minimum distributions. However, for some people, taking money from tax-deferred savings at age 71 may not be desirable (especially if they want to pass amounts to heirs at death). While Roth 401(k)s do appear to be subject to the minimum required distribution rules, Roth 401(k) distributions can be rolled over into Roth IRAs, which do not require distributions.
Expect interest in Roth 401(k)s to come both from younger workers with long-term investing horizons, and from older workers who as high-earners are barred from contribution to a Roth IRA or who want to maintain their 401(k) savings as a tax-free nest egg for their heirs.
To better illustrate the circumstances in which Roth 401(k)s can be advantageous, some examples follow.
Example 1: Johnny on the Spot
John, who is 45 and likely to retire at 67, generally contributes the maximum to his 401(k) plan. His overall federal and state tax rate is 40 percent, and he is considering a Roth 401(k) contribution.
Here are the decision steps John faces:
1. John must consider that the contributions are fully taxable upfront. If he chooses a $15,000 Roth 401(k) contribution, he will have to pay the $6,000 taxes on the contribution from somewhere else. That $6,000 will then not be available to him and he will lose the earnings on that $6,000 over the next 22 years (less the taxes he would pay on the earnings).
2. John needs to determine whether his tax bracket is likely to change when he retires. If he is covered by a pension plan and holds significant investments, John may be in the same tax bracket for many years after retirement. On the other hand, without a pension, John's tax bracket may drop from 40 percent to 25 percent during retirement.
3. John needs to decide whether his return on investment (ROI) outside of the plan will be significantly better than his ROI inside of the plan. If John makes a traditional 401(k) contribution and puts what would otherwise be his $6,000 tax payment into a high-yield investment outside the plan, he might be better off because his rate of return (even after yearly taxes) will be high. But if John puts the $6,000 into a money market account outside the plan, where it would earn significantly less, he may have been better off making a Roth 401(k) contribution with after-tax dollars.
4. John needs to decide whether he believes the tax rates currently in effect will be higher or lower when he retires. This is not an easy projection. Within the last 20 years, top federal income tax rates have been as high as 70 percent and as low as 28 percent. If John thinks the income tax rates will increase, paying tax at 40 percent may be better than paying higher rates later (especially if John's income is otherwise expected to be steady).
If John thinks the tax rate is likely to drop, he would not generally want to choose a Roth 401(k). Likewise, if John's tax rate is likely to remain the same and his return inside or outside the plan would be reasonably comparable, the Roth 401(k) may not be worthwhile.
And here are a few possible outcomes:
• John decides on a Roth 401(k) contribution but also decides not to pay tax from another source, so he reduces his Roth 401(k) contribution to make up for the taxes. Instead of contributing $15,000, John contributes $9,000. Assume John's tax rate remains the same for the whole period and that he will take a lump sum at age 67, and that the plans internal rate of return is 6 percent (compounding monthly). At age 67, John's $9,000 Roth 401(k) contribution is worth $33,580, none of it taxable.
• If John contributed $15,000 to a traditional 401(k), it would be worth $55,970 but he would pay $22,388 in taxes. Thus, his after-tax distribution would be $33,582. Given rounding differences, he comes out the same.
• If John retires when his top tax rate is 50 percent instead of 40 percent, he would pay approximately $27,985 in taxes and have only $27,985 remaining. However, if John's tax rate dropped below 40 percent at age 67, the regular 401(k) contribution would be the better deal.
Example 2: Mary's Moving Up
Mary is 30, in the 25 percent tax bracket and will retire at age 67. She expects her income to rise considerably and thus her tax bracket will be 40 percent later in her career. Mary thinks she can save $10,000 this year. She must go through many of the same decision steps as John (see above), but she already knows that her tax rate is likely to increase and that she has many years before retirement.
Some possible outcomes:
• If Mary puts $10,000 in as a regular contribution she will not pay federal income tax on the amount now. Assume that Mary would take a lump sum distribution at age 67. The $10,000 contributed to the plan pre-tax would grow (6 percent compounded monthly) to approximately $91,565, but she would pay approximately $36,600 in tax on the distribution. Her distribution would thus be $54,965 after tax.
• Because she can only save $10,000, if she chooses a Roth 401(k) Mary will contribute $7,500 to the plan and will pay the $2,500 as tax. However, at age 67 she will pay no tax on the distribution, which includes 37 years of earnings. Assuming a 6 percent return (compounding monthly), her $7,500 contribution will be worth approximately $68,674 tax free.
• As these calculations show, present and future tax brackets make a big difference in deciding between a regular or Roth 401(k) contribution. To reiterate, if a person in a high tax bracket expects the tax bracket to drop after retirement, a Roth 401(k) may not be the best choice. A young person in a lower tax bracket, however, could well decide that a Roth 401(k) makes more sense.
Plan Administration: Steps to Take
For plan administration purposes, Roth 401(k)s are generally treated as elective contributions, just like traditional 401(k) contributions. The two types of contributions are added together to determine whether the contribution limits are satisfied and are counted together in the discrimination tests, such as the average deferral percentage (ADP) test.
However, you'll need to take these administrative steps:
• Change the election form to allow employees to designate certain amounts as Roth 401(k) contributions
• Adjust the payroll system to determine the tax on Roth 401(k) contributions and withhold it from some other source. This is currently done with FICA on traditional 401(k) contributions so it's not a major step, but employees need to realize that their paycheck will be reduced more than for a regular 401(k) contribution.
• Prepare to separately track Roth 401(k) contributions and earnings.
• Separately report such distributions. For example, if an employee takes both traditional 401(k) distributions and Roth 401(k) distributions, the Form 1099-R reporting system must be able to distinguish between the two types.
• Keep track of the date of employees' first Roth 401(k) contributions. A Roth 401(k) only affords special tax treatment if the employee has contributed for at least five years.
• Determine whether Roth 401(k) distributions are being rolled over into another plan's Roth 401(k) account or into a Roth IRA. If an employee has made both traditional and Roth 401(k) contributions, the plan administrator will need to separately roll over the traditional contributions to a traditional IRA, and the Roth 401(k) contributions to a Roth IRA.
• Provide additional employee education.
While none of these steps are difficult, especially for plan administrators working with experienced third-party administrators, small plans kept in-house may have to decide whether the extra steps are worthwhile.
A Valuable Option for Some
Employers need to be aware of all retirement strategies available to their employees, especially if they want to remain competitive. Roth 401(k)s can be another valuable option that employers can bring to the table. And if they do so, HR professionals have a responsibility to help participants weigh the pros and cons of choosing a Roth versus traditional 401(k) deferrals.
Karen M. Field is a director in the Compensation and Benefits practice at KPMG LLP, based in Washington D.C.
The Ins and Outs of Roth 401(k) Plans, Wall Street Journal, March 2012
Favorable Tax Environment Adds to Roth 401(k) Appeal, Vanguard Group, January 2012
Roth 401(k)s: Slow Start, but Welcome Where Tried, SHRM Online Benefits Discipline, December 2006