Why Roth? Benefits for Plans and Participants

In the ever-evolving landscape of retirement savings, the adoption of Roth 401(k) plans has surged, driven by legislative changes and growing awareness.

In a Roth 401(k), contributions are made with after-tax dollars, meaning taxes are paid upfront. However, withdrawals in retirement, including both contributions and earnings, are typically tax-free, provided certain conditions are met.

Because the Roth 401(k) offers individuals the potential for tax-free growth and flexibility in retirement planning, it’s an attractive option for many savers which has led to widespread adoption. Those benefits have drawn about 80% of plan sponsors to offer it in plans, according to the most recent DC Benchmarking Survey from PLANSPONSOR, which is a sister publication of PLANDADVISER. But experts expect greater pickup by participants in coming years, both due to education and legislation that will make Roth offerings more prevalent.

The Landscape

Jenna Witherbee, a financial adviser at 401(k) Plan Professionals, says most of her plan sponsor clients do offer a Roth option to employees.

“I think it’s probably 99% right now, especially with the recent changes with SECURE 2.0 we know that all employers will eventually have to have Roth,” says Witherbee. “Even though a Roth 401(k) has been around since 2006, it has taken us over 15 years for it to get almost total adoption.”

She says the delay in Roth 401(k) adoption could be due to logistical complexities, involving plan administrators and payroll managers, as well as setting up an additional payroll code. She believes plan sponsors might also have assumed participants wouldn’t not need a workplace Roth since they would set up a Roth IRA on their own.

“I think [plan sponsors] thought that their participants just wouldn’t really want it or wouldn’t use it; or that it would be some huge burden on them from an administrative standpoint,” she says.

According to Witherbee, participants do get stumped by some of the complexities of a Roth 401(k), such as pretax versus Roth. Advisers should therefore continuously be educating and having conversations with people about the savings vehicle.

“We always like to cover this in employee education sessions,” she says. “I feel like a lot of people have heard about it, but maybe don’t know exactly what it is, and a lot of participants confuse it with a Roth IRA.”

Demographics

Richard Craft, founder and CEO of Wealth Advisory Group, says the participants that benefit from a Roth 401(k) tend to be those early in their career, typically lower income and younger employees.

“The strategy is this: Say I’m in my 20s or 30s, I’m building my career and hopefully my income will be higher in the future,” he says. “Getting money into the Roth is really important because of the compounding interest investment return aspect of money.”

A participant puts money into the Roth early in their career and then switches to a traditional, pre-tax 401(k) when their income rises or when tax rates increase.  

Craft says another demographic that can greatly benefit from Roth 401(k) are those mid-careers or later in their careers. They may be putting nothing but traditional contributions into their retirement savings and their income level is at where the Roth IRA is either not available to them, or simply just not impactful enough at $7,000, the maximum limit for an IRA.

Meanwhile, they could be putting larger amounts into their Roth 401(k) option through deferrals and catchups. 

“If you ever want to build a significant Roth bucket, you need to just switch and change your mind. Fill up the Roth with, for many of those people, likely the $30,500 contribution amount out of their paycheck [when making catch-up contributions],” he says. “We focus on that group as being a very suitable audience for Roth.”

Plan Design

When it comes to plan design, contributing is the foremost component advisers should add into the plan, allowing participants to contribute on a Roth basis via their payroll, according to Jason Aceituno, director of financial services at Sequoia.

He says another option is to include plan Roth conversions. Participants can take a portion of their pretax money and convert it to Roth throughout the year. They pay taxes on that money that year, but once it’s converted, that bucket of money turns into Roth and, from that point, follows Roth rules.

“The other big plan design option is mega-backdoor Roth,” he says. “There is a feature out there in which we can do additional after-tax contributions with an in-plan Roth conversion to allow folks to contribute in addition to the IRS limit. It’s really from a backdoor standpoint to get more money into their Roth accounts.”

Another option is employer contributions in the form of Roth, which came out in 2022 via the SECURE 2.0 Act of 2022. It’s a relatively new solution that hasn’t really been rolled out with many recordkeepers, but Aceituno anticipates the solution will expand rapidly.

“In-plan conversion is already happening. Mega-backdoor Roth is already happening,” he says. “The newest one is the employer contributions in the form of Roth. That’s going to be very big over the coming years.”