Alternative Thinking – Interest in the Roth 401(k) Option Continues to Expand

Roth 401(k)s offer employees the ability to pay taxes now and enjoy tax-free growth of their retirement plan assets just like Roth IRAs. Offering Roth 401(k)s to employees is a useful benefit that can be added to most 401(k) plans.

But whether to choose the Roth 401(k) is not an easy decision for most employees.

A Roth 401(k) is a retirement-savings option that may be offered by employers in addition to a traditional 401(k) plan. Both these plans allow employees to designate a portion of their current salary to be contributed to the plan with the intention of using it to pay for retirement expenses in the future. The essential difference between these two types of 401(k) options is that, unlike a traditional 401(k) plan, contributions to a Roth 401(k) are made with after-tax dollars. As a result, qualified withdrawals from Roth 401(k)s are not subject to income taxes, unlike withdrawals from a traditional 401(k). Employer contributions or matches will be made on a pre-tax basis, the same as a traditional 401(k).

The Roth 401(k) first became available in January 2006. According to benefits consultant Aon Hewitt’s 2014 Universe Benchmarks report, more than half of 401(k) plans offered Roth options in 2013, which was up from 40{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} in 2011. In the same study, Aon reported that, when the option is available, 11{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of participants choose a Roth 401(k). For younger workers in their 20s, 17{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} chose the Roth 401(k) option. And, as we will discuss, this is the group of employees most likely to benefit from choosing a Roth 401(k).

Let’s look at some important features of the Roth 401(k):

• There is no income ceiling for contributors — employees at all income levels are able to make contributions.

• Contributions are made with after-tax dollars, and qualified distributions may be withdrawn without tax or penalty.

• Contribution limits for 2015 are the same as a traditional 401(k) or 403(b) — $18,000 per year and $6,000 additional catch-up contributions if you are over 50.

• After age 59 ½ — and at least five years after the first contributions to a plan — investment earnings can be withdrawn tax-free.

• Minimum annual distributions must begin at age 70 ½, though a Roth 401(k) can be rolled into a Roth IRA, which does not require withdrawals.

• Employer contributions or matches will be made on a pre-tax basis, the same as a traditional 401(k).

For employees, it is not easy to decide whether to contribute to a traditional 401(k) or a Roth 401(k) since part of the equation is making predictions about future tax rates and your own income in retirement. If you expect to be in the same or a higher tax bracket when you retire, a Roth 401(k) could result in greater savings. However, if you think you will be in a lower tax bracket after you stop working, it may be preferable to contribute to a traditional 401(k). The younger you are, the more compelling the Roth 401(k) is likely to be.

Some people may decide to contribute to Roth 401(k)s to diversify their tax exposure in retirement, rather than paying income tax in retirement on all of their 401(k) withdrawals. Other people may find Roth 401(k)s compelling because they can effectively save more money for retirement by paying taxes now rather paying them after they stop working.

Let’s look at some situations that apply to physicians and other healthcare employees.

A young resident in her 30s just starting out in the workforce may anticipate that her future earnings will be much higher and thus will be subject to higher tax rates. This person is likely to find contributing to a Roth 401(k) to be advantageous until she is in a higher tax bracket. She can fund the Roth 401(k) now with after-tax dollars and never have to worry about paying taxes on it in the future.

Meanwhile, a physician or executive in the middle of his or her career may currently be in one of the top tax brackets. In this case, contributing to a traditional 401(k) will allow him to defer taxes now when his tax rate is high and pay them in the future when his tax rate is lower.

Finally, a physician near the end of his career who will likely be in the same or higher income-tax bracket during retirement may benefit from contributing to a Roth 401(k). Making contributions now to a Roth 401(k) using after-tax dollars will eliminate the possibility that these dollars will be subject to higher taxes in the future.

For employers, if you don’t currently offer a Roth 401(k), ask your plan administrator or consultant about adding this option. For employees, if you decide to move forward with a Roth 401(k), make sure you review how it will impact your net take-home pay. It is recommended that you ask your payroll department to calculate the difference in net take-home pay between contributions to a Roth 401(k) and a traditional 401(k). v

Doug Wheat, CFP, is a certified financial planner with United Capital Financial Advisers, LLC; www.unitedcp1.com/ma1