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Roth 401(k)s Expected to Join the Mainstream

December 12, 2008
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Employers are adopting Roth 401(k) savings plans faster than employees are embracing them, but many observers expect the plans to join the mainstream of employer-sponsored retirement packages in the coming years.

The relatively new type of savings plan permits employees to make after-tax contributions and, if certain conditions are met, receive retirement distributions that are tax-free.

According to a September survey of 1,000 employers by the Chicago-based Profit Sharing/401k Council of America, about 30 percent of 401(k) plans offered a Roth 401(k) feature in 2007, up from 18.4 percent the previous year. However, only 12.6 percent of employees used that option in 2007, up from 11.6 percent the previous year.

Still, observers say Roth 401(k) plans, which were authorized under a provision of a 2001 law that took effect in 2006 and were made permanent under a 2006 pension law, will become more popular.

“They’re not commonly available nor commonly used, but availability and use is growing,” says David Wray, president of the Profit Sharing/401k Council of America.

A Roth 401(k) offers some of the advantages of Roth individual retirement accounts and traditional 401(k) savings plans. Roth 401(k)s allow workers to contribute after-tax dollars and receive distributions tax-free as long as the worker is at least 59½ years old and five years have elapsed since the first contribution was made.

Traditional 401(k) plans are funded with pretax dollars, but those contributions and accumulated investment earnings are taxed when withdrawn.

Roth IRA accounts also use after-tax dollars but limit workers to $5,000 in annual contributions.

Under federal rules, employees can decide how much to allocate to their Roth 401(k) account and how much to contribute to their traditional 401(k), but the combined contributions currently cannot exceed $15,500. The accounts were expected to appeal to workers who anticipate being in a higher tax bracket when they retire and higher-paid employees who want to save more for their retirement.

Slightly more than half of workers already using Roth 401(k) accounts also invest in a traditional 401(k) or another account, according to a 2006 survey by Fidelity Investments.

Many observers say the 2006 Pension Protection Act that made Roth 401(k) plans permanent assured employers and was a key impetus for the recent increase in the number of organizations offering such plans.

Most industry estimates are similar to the findings in the survey by the Profit Sharing/401k Council of America.

Pam Hess, director of retirement research at Hewitt Associates in Lincolnshire, Illinois, says the consultant’s latest survey showed that 19 percent of employers had Roth 401(k) plans in 2007, and that 11 percent of employers without the plan said they were very likely to add one this year and another 23 percent said they were somewhat likely to add one.

Eventually, Hess says, half of employers are expected to have the Roth option as part of their 401(k) plans.

The first employers to add the Roth option to their 401(k) plans generally were professional firms—medical practices, law firms, consultants and other businesses in which employees had financial advisors or were sufficiently knowledgeable about finances to ask for the new Roth option, Wray says. Most were smaller firms, he says.

“The 401(k) plan in a small company is the retirement plan for the CEO. Whereas, as you get to larger and larger companies, the retirement plans are more customized for senior management,” Wray says.

Since then, firms in different industries, such as manufacturing, have followed suit, observers say.

“I’m seeing retail organizations—companies that were not at all interested a couple years ago—are now putting [Roth 401(k) plans] in,” says Bill McClain, a Seattle-based consultant with Mercer.

Still, as the number of employers adding the option has increased, the portion of workers using the plan remains low. Hewitt’s Hess says 4 to 17 percent of workers use the Roth 401(k) option when offered; McClain says he thinks that figure is about 5 percent.

Observers say most of those using the option are young workers—because they earn less, are taxed less, and expect their pay and tax rate to rise in the future—and new hires, 25 percent of whom use the Roth option when available, according to the Hewitt survey.

Hess says the percentage of users will increase as more employees become aware of the option.

“We’ve come a long way,” she says. “When Roth first came out, there was a lot of fear that employees wouldn’t know what to do with it.”

Hess and others say worker confusion remains a concern for employers considering offering the Roth option as part of their 401(k) program. She says businesses should explain the new option frequently and in detail to avoid wasting the effort and time of implementing a new plan that few workers use.

“It’s not like clicking a button. There’s a lot of work. It often costs money to do it from the employer’s perspective,” Hess says. “The small number of firms that added [the Roth option] that didn’t communicate heavily—those are the companies that have the lowest utilization.”

“You want to make sure you make a splash, employees know it’s available and, from the employer’s perspective, that you get credit for doing it,” Hess says.

She and McClain say the more recent global financial crisis could slow the adoption of Roth 401(k)s, although one could argue the reverse.

“You have an aging demographic, the ongoing wars in Iraq and Afghanistan, and then throw in the financial bailout,” says McClain. “There are some people out there who think increased tax rates are inevitable, despite what we heard from both presidential candidates. That would, of course, favor investing in a Roth.”

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