For boomers who have been looking to combine the tax treatment of a Roth IRA with the corporate matching dollars they get when contributing to a 401(k), the wait may soon be over. Spurred by the Pension Protection Act of 2006, a growing number of companies are offering a Roth option to their 401(k) plans — and employees are buying them up.
“Since the passage of the Pension Protection Act, we’ve seen a doubling in the number of 401(k) plans that offer a Roth option,” says Steve Wilt, an advisor and team leader of the Star Group unit of Merrill Lynch, Akron, Ohio. “It’s really starting to take off.”
Since the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, plan sponsors have been allowed to incorporate after-tax Roth contributions into both 401(k) and (for non-profit employees) for 403(3)(b) plans. The Roth-enabling provision of EGTRRA was, however, set to expire in 2010; the Pension Protection made the provision permanent.
A March 2008 survey from Hewitt Associates, Lincolnshire, Ill., shows that approximately one-fifth (19%) of employers currently offer a Roth 401(k) to their employees, up from 12% in 2007. Among those companies that do not offer a Roth 401(k), 11% said they are very likely to add one in 2008.
Also noting an upswing in Roth 401(k) plan adoption by its client-base is Merrill Lynch. A survey by the New York-based company’s Retirement Group reports a 21% increase during the first quarter of 2008 in plans incorporating a Roth 401(k) feature. Assets in Roth 401(k) accounts total $70 million, with $28 million contributed during the first 3 months of this year. The average Roth contribution in Merrill Lynch’s plan-base is approximately $5,400.
Kevin Crain, a managing director Merrill Lynch’s Business Retirement and Corporate Market Integrated Benefits business, says that professional services firms have experienced the greatest penetration. Medical practices, law and accounting firms, and consulting agencies accounted for fully one quarter of the increase in plan adoption enjoyed during the first quarter.
“What’s happening now, particularly at professional services firms, is that people are learning about the Roth 401(k) and encouraging senior executives within their companies to make it available to employees,” says Crain.
In contrast to a standard 401(k), Roth 401(k) contributions are invested using after-tax (rather than pre-tax) dollars, but distributions are tax-free; standard 401(k) contributions are taxed at distribution. The different tax treatment, sources say, has no effect on a plan participant’s balance, assuming the same rate of return and tax rate for both plan types.
For all but the most disciplined savers, however, the Roth 401(k) has an edge. That, say market-watchers, is because the vehicle lets individuals invest more on a tax-advantaged-basis: An after-tax Roth contribution of $11,625 is equivalent to the pre-tax limit of $15,500 that plan participants can invest in a regular 401(k). But Roth contributors can also invest up to the same $15,500 limit. To duplicate the Roth’s plan balance at distribution, regular 401(k) savers would have to invest their pre-tax savings–the dollars that otherwise would have been taxed under a Roth plan.
Sources says the Roth 401(k) will generally be most attractive to young plan participants who expect their incomes will rise over time. But individuals who expect to be in a lower income bracket at retirement would be better off in a regular 401(k). Those boomers who are unsure what income bracket they’ll occupy at retirement might consider dividing their contributions between regular and Roth 401(k) plans, say experts.
“The Roth 401(k) will especially appeal to savvy investors who understand the vehicle’s after-tax features,” says Barb Hogg, a senior retirement consultant at Hewitt Associates. “We’re also seeing high usage rates among first-time employees who have to make decisions about their employer-sponsored retirement plans. Among many existing employees, there is still a lot of inertia.”
In the Merrill Lynch survey, more than 13,000 plan participants (or 6% of those eligible in plans offering the option) are contributing to a Roth 401(k) account. The number of participants contributing is up 37% in the first quarter of 2008. Almost 20% of plans with the Roth 401(k) have participation rates of 10% or more. And 10% of plans have participation rates of 20% or more.
Both Hogg and Crain credit the growing interest among boomer participants in part to the development of online calculators and tools that guide them in making informed decisions about where and how much to invest. For employers, advanced software is also a must to ease plan administration.
“The Roth 401(k) entails an additional administrative burden because employers have to add a source code to their payroll identifying Roth contributions,” says Crain. “Companies have to ensure they have the appropriate technology and payroll interface so [a Roth option] doesn’t add more work. If they don’t have the technology in-house, they should look to a third-party administrator.”
They may also have to turn to Washington–and, when necessary, lobby their senators and representatives–to ensure that Congress doesn’t fiddle with the tax-free treatment now accorded Roth distributions. Given the growing prospect of a recession and reduced tax revenues, not everyone is so confident.
“There is a good deal of skepticism among the clients I talk to,” says Tom Nihoul, a certified financial planner and principal of Nihoul & Associates, a Spokane, Wash.-based financial advisory practice affiliated with Ameriprise Financial. “Many question whether Congress won’t change the tax laws to make Roth 401(k) distributions taxable.”