Should you use the Roth Retirement Savings Option?

We’ve had Roth options in 401(k) plans for a while now and Roth IRAs even longer. It gave people the opportunity to experience how Roths can provide savings benefits for retirement and other financial needs.

The Roth option has generally been viewed solely from a retirement perspective.

“The Roth IRA can be profitable in retirement because it provides you with a tax-free source of income,” says Herman (Tommy) Thompson, Jr., financial planner at Innovative Financial Group in Atlanta. “The traditional 401(k) and the traditional IRA payment right now. Traditional contributions get a federal and state tax deduction for the current year, making it easier to save. The Roth doesn’t get no tax deduction. Also, some states (like Georgia) have rules that reduce or eliminate state tax on retirement distributions. The Roth 401(k) and Roth IRA are just not as attractive in these states.

The decision between using a traditional tax-deferred retirement savings vehicle and its Roth counterpart may seem complicated, but the math is simple.

“If tax brackets remain constant over a long period of time, the assets available for after-tax distribution will be identical under a Roth IRA and a traditional IRA,” says Marcia S. Wagner, president/founder of The Wagner Law. Group in Boston. “A traditional deductible IRA will provide better results than a Roth IRA if the individual’s tax rate at the time of the distribution will be lower than it was during the contribution phase.”

For several years now, America has been in a low tax environment. Many think it won’t last. The math tells you that the Roth should be the preferred retirement savings alternative. There are, however, very good reasons why fewer people than expected are using Roths.

The most obvious reason is that they can’t.

“Couples who are married and filing jointly are often not eligible because they exceed income limits ($214,000 in 2022),” says Daniel G. Dolan, principal at TFB Advisors, LLC in Overland Park, Kansas. “Roth 401(k)s have no income limits and are now available in 70% of employer-sponsored plans. However, only 18% of participants contribute after-tax dollars to their 401(k). As a newer and less understood option, it is vastly underused. »

Yet there’s also an obvious reason why you don’t see as many employees using Roth 401(k) plans.

“Plans that use pre-tax auto-enrollment will generally see lower Roth utilization,” says Kit Gleason, vice president/senior relationship manager, First Bank & Trust, Sioux Falls, South Dakota. “The feature overcomes participant inertia when it comes to the savings decision, but the same participant inertia applies when it comes to making the pre-tax choice versus Roth.”

The default option in the tax-deferred alternative represents an inherited way of thinking on the part of those who design 401(k) plans. Today’s employee demographics challenge this ongoing strategy.

Jack Towarnicky, Of Counsel at Koehler Fitzgerald, LLC in Powell, Ohio, says, “More than 95% of 401(k) plans with automatic features require employees to make pre-tax contributions by default, even though: 1) Most new hires are made at the bottom of a marginal income tax bracket as they will experience it during their working career; 2) Most non-participants (if you ‘sweep’) can be in as low a marginal tax bracket as they will ever see for the rest of their lives; and, perhaps most importantly, 3) The median tenure of American workers continues to be less than five years, so when the separation occurs before age 55 (or 59½), a distribution of pre-tax contributions would not only be subject to marginal rates. income tax rates (federal and state) but also, potentially, a 10% excise tax for early withdrawal.

Many plans have not yet added Roth conversion features into the plan. Towarnicky attributes this to “executives, particularly those who live in states with no income tax or those with low state marginal income tax rates, have not reconsidered the value of using of a Roth”.

Towarnicky suggests four reasons why adding a Roth option might make sense:

  • The ability to take advantage of today’s low marginal income tax rates.
  • Converting to a Roth IRA avoids the application of the required minimum distribution rules.
  • For an executive in a 33% marginal tax bracket who contributes the regular 402(g) and catch-up 414(v) maximums in 2022 (that would be $27,000), contribute the same dollar amount on a Roth basis would be the equivalent of a contribution of $40,300 before taxes.
  • Roth asset distributions after retirement do not increase Modified Adjusted Gross Income (MAGI) for the Monthly Income-Related Adjustment Account (IRMAA) for Medicare Part B and Part D premium purposes.

Even so, even when the Roth option is available (whether through a 401(k) or IRA), retirement savers simply don’t have access to it. To some extent, and particularly among older savers who have become entrenched in the priority of saving taxes today, the Roth simply does not offer what they are looking for.

Retirement savers are drawn to “immediate gratification,” says RL “Dick” Billings, senior documents and compliance specialist for PCS Retirement in Jefferson, South Dakota. “They can better understand the tax exclusion up front, but not the income exclusion many years later. The Roths are generally best for young people, but it’s hard to quantify the value of such income exclusion 40 years from now.

Assuming tax rates will rise, the Roth option makes the most sense. Still, people love the feeling of deferring taxes now.

“Many people avoid a Roth option despite qualifying for it because contributing to a traditional option helps reduce taxable income, which can help save a person money when their tax bill is due. “, says Erik Wright, owner of New Horizon Home Buyers in Chattanooga. , Tennessee.

“This is a rather short-sighted approach that can leave a portfolio too heavily focused on long-term tax-deferred investments,” says Ryan McKeown, senior vice president financial advisor at Wealth Enhancement Group in Mankato, Minnesota. . “A lot of people don’t even realize they have a Roth 401(k) option available in their plan. It’s a matter of education. »

It is important to recognize that short-term circumstances can make long-term choice impossible.

“With so many workers living paycheck to paycheck,” says Kenneth Dean, senior director of financial planning at Winthrop Wealth in Boston, “they’re now choosing tax savings over funding the ‘Roth option with after-tax contributions because less is left over for daily living expenses.’

There are many good reasons to use a Roth retirement savings option. There are also situations where it makes sense to use a tax-deferred retirement savings account instead. Which choice best suits your situation?