The Case for Roths

Art by Hayden Maynard

In the early 1960s, Walter Mischel, a Stanford University psychology professor, devised what became known as “the marshmallow test” to study the influences of choice and self-control in young children: A child is given the option to eat one marshmallow right away, or enjoy the reward of two marshmallows if he can wait a few minutes—sitting alone in a room with both treats.

Participants in 401(k) plans face their own high-stakes version of the marshmallow test: enrolling in a conventional 401(k) with an immediate reward—pretax contributions with little apparent effect on their current take-home pay—or electing a Roth 401(k) where contributions are taxed and paychecks are lower, but receiving delayed gratification through reduced taxes and greater flexibility in cash flow during retirement.

The benefits to be had from Roth plans can be significant, but, despite their widespread availability, uptake by participants has been relatively slow.

Roth plans are undeniably complex, and the shortfall may be due to participants’ confusion. Or it may be just the allure of enjoying one marshmallow now. “Unfortunately, most Americans think more about today than the future, and the higher paycheck from a pretax 401(k) seems more comfortable,” says Delvin Joyce, a financial planner with Prudential Financial in Charlotte, North Carolina. Therefore, consultants and advisers have been trying to replace education stressing Roth’s technical aspects with simpler, more resonant explanations tied to analogies and potential outcomes.

While they may lack the appeal of an immediate tax deferral, Roth 401(k) plans can confer multiple and substantial benefits. “In a simple case, assuming that tax rates today and at retirement will be the same, a participant gets to the same account balance and would be indifferent [as to whether it was] a Roth or a pretax 401(k),” observes Martha Tejera, head of plan consultants Tejera & Associates in Seattle.

But real-life conditions are rarely so simple. “Many younger workers just starting out expect their tax rates to be higher in the future, which could make the Roth structure more advantageous,” Tejera says. And it is not just about tax rates. In terms of higher-income participants, she adds, “If someone is up against the maximum deferral, putting those dollars in a Roth saves about one-third, irrespective of the tax rate. Those dollars have already been taxed, and that $18,000 is the equivalent of $24,000 in pretax dollars.”

She also notes that taxes paid in retirement on Social Security benefits are determined by the amount of other taxable income. “For retirees drawing from conventional 401(k)s, 85% of their Social Security benefits may be subject to tax, but if retirement income is taken from a Roth, it’s not taxable, and there’s no impact.”

Roths offer greater flexibility in cash flow as well. “People who have considerable income in retirement may be able to avoid some of the required minimum distributions when they reach age 70 1/2 by having a Roth in place,” says Mike Shamburger, head of territory sales for T. Rowe Price Retirement Plan Services, in Owings Mills, Maryland.

Roughly 72% of plans offer a Roth contribution option, according to the 2018 PLANSPONSOR Defined Contribution (DC) Survey, which covered 4,000 DC plans. Roth availability was more prevalent at the largest plans—nearly 79% for those over $1 billion in assets—but comparable across other plan sizes. While 76.5% of plans match participant contributions for their plan overall, just 69.4% both support and match Roth contributions, although more often at larger plans.

The actual participant use of Roth plans is scant. T. Rowe Price Group reports that, among the 600 plans and 1.6 million participants studied for its “2017 Reference Point” report, just 6.9% of participants made Roth contributions, rising slightly from 5.8% in 2014.

Few sponsors have made Roth 401(k)s their default structure, perhaps from a reluctance to make tax decisions for participants. “That’s a valid argument,” Shamburger says. “With pretax plans, the benefits are pretty much the same for everyone, while with Roth accounts they’re more subjective to the individual.”

Marina Edwards, senior director of retirement with Willis Towers Watson in Chicago, points out, “Sponsors have been making ‘paternal’ tax decisions for participants all along, by automatically enrolling them in a pretax 401(k). If Roth can provide a better outcome for some, why not select that for them instead?”

Without defaults in place, the choice of Roth vs. pretax has to be guided, and educating participants on the complexities of Roth has been challenging. “When people don’t understand something, they’re not likely to take action on it,” Edwards observes.

“Age 50 is usually when the alarm goes off, and people realize, ‘I’m actually going to have to get ready for retirement,’” Shamburger says. However, with Roth plans, T. Rowe Price finds that the message is most resonant among participants ages 20 to 40 and has reached about 9% of those participants as of 2017. “There’s a contradiction there,” he says. “Those are the folks you would think live in the moment and are less related to something as far off as retirement.”

“Part of the disconnect is inertia,” says Jim Sampson, director of retirement advisory services for Hilb Group Retirement Services in Warwick, Rhode Island. “For too many people, their 401(k) is like a health club, where they sign up but never go back. And that lack of attention goes hand in hand with the industry using too much jargon.” What he finds most effective in increasing Roth participation is one-on-one or small group meetings, “focusing on the basics and ‘Fisher-Pricing’ it for everyone.”

Many advisers also promote Roth accounts by borrowing a familiar concept from investing. “Participants don’t know what’s going to happen in the markets, so they diversify their investments,” Edwards says. “Nor do they know what future tax rates will be, and they can diversify by paying current taxes through a Roth 401(k).” She adds that recent reductions in federal income tax rates make this choice more appealing through 2025 and provide a greater payoff to converting from traditional to Roth accounts.

“I think people find ‘diversification of taxes’ too confusing,” Sampson says. “Instead, I say, ‘You never get away completely from paying taxes, but if you adopt a Roth for part of your savings and pay the taxes now, you’ll have a bucket of money that you won’t be taxed on in retirement.’”

“If the education is too technical and talks about all of the options and flexibility, it can be overwhelming to participants to the point where they just go with the pretax choice,” Shamburger says. He advocates an approach through “personas”—representative profiles of hypothetical people at several career points and in several financial positions that participants can relate to.

Consultants at Willis Towers Watson go a step further, modeling simulations of retirement options for individual participants. “We’ve been able to demonstrate, using reasonable assumptions on growth in participants’ salaries and the likelihood that their tax rates will be higher, that people may be able to retire from eight months to two years earlier if they go with a Roth 401(k),” Edwards says.

Retire two years early? That’s like getting the second marshmallow.