The Role of Roth 401(k) in Retirement Savings
Point of View
Introduction
Most financial experts agree that a Roth 401(k) savings feature can provide a significant benefit to a variety of savers—from high paid employees to lower income workers. And after two years of being pushed to the back burner, Roth is gaining momentum in defined contribu- tion plans and emerging as one of the strongest trends for 2010 and 2011. A growing number of plan sponsors are adding a Roth 401(k) or Roth 403(b) option, and many more are expected to implement in the coming years.
Roth 401(k) contributions were introduced beginning January 1, 2006. At that time, plan sponsors were reluctant to implement the feature given the infancy of the option as well as its possible expiration in 2011. However, the Pension Protection Act of 2006 established the Roth 401(k) feature as a viable, long-term savings option in qualified plans by removing the sunset provision. In addition, new rules now allow the conversion from a qualified plan or a traditional IRA to a Roth IRA without any income limits. Further, pending legislation would also allow conversions of before-tax and after-tax money into a Roth account within a 401(k) plan.
Background on Roth 401(k) Provisions
A Roth 401(k) feature allows participants to make after-tax contributions to their 401(k) plan, which accrue earnings tax-free and allow for tax-free distributions in retirement.
Apart from differences in tax treatment, Roth 401(k) contributions bear many similarities to before-tax 401(k) contributions:
n Unlike Roth IRA contributions, there are no income limits for making Roth 401(k) contributions.
n Employee contribution limits, in total, are the same as before-tax contributions—
$16,500 for 2010, significantly higher than the Roth IRA at $5,000.
n Plan sponsors may match Roth 401(k) contributions.
Loans and certain withdrawals are permissible.
While Roth 401(k) is relatively new for most plans, to date, participant usage has been significant, especially among newly enrolled employees. As a result of this demand, more plan sponsors are adopting Roth.
This paper delves into more detail on employer adoption of a Roth 401(k) feature as well as participant behavior among plans that have implemented the option.
Employer Adoption
Recent data shows that employer adoption of Roth is gaining momentum. While a limited number of plans were early adopters of a Roth 401(k) in 2006, sentiment changed with the Pension Protection Act (2006) and Roth 401(k) permanence. As a result, employer adoption increased markedly in 2007. However, imple- mentations plateaued during the financial crisis in 2008 and 2009, due to limited budgets and competing priorities. More recently, plan sponsors have begun turning their attention back to Roth 401(k), given pending regulatory changes, improved tools, and proof that employee usage justifies the implementation.
Hewitt’s 2010 Hot Topics in Retirement Survey found that 29% of mid- to large-sized employers currently offer a Roth feature. Further, among those not allowing Roth contributions, 25%
said they are very or somewhat likely to add the feature during 2010.
Prevalence of Roth 401(k) Feature
For those plan sponsors reluctant to add a Roth 401(k) during 2010, the largest barriers noted were the potential lack of participant usage (54% of respondents) as well as the administration complexities and/or cost of implementation (51% of respondents). But adding a Roth feature is not as simple as clicking an on/off switch—it takes considerable planning, implementation, and communication.
Communication is especially important, and tools must be made available to help employees navigate this new and complex decision.
Employer Adoption—Summary Facts
n 29% of employers currently offer Roth 401(k), and among those not offering Roth, 25% are likely to add it in 2010.
n Significant future adoption is expected, propelled by employee demand and pending regulatory changes.
Future Direction Very Likely 12%
Somewhat Likely 13%
Unlikely 75%
Current State Already Have 29%
Don’t Have 71%
Employee Usage
Some plan sponsors do not believe that a significant number of their employees would use a Roth feature if it were made available. As a result, implementation has been slower than expected. However, now that early adopters of Roth 401(k) features have several years of usage data, a clearer picture of strong usage by plan participants is emerging. In addition, the data shows some significant benefits for those participants who take advantage of a Roth 401(k) option.
In this analysis, more than 20 plans were examined through year end 2009, covering 504,000 eligible 401(k) participants. Nearly all of the plans provided the same match structure for a Roth 401(k) as for before-tax, and permitted loans and withdrawals from a Roth 401(k). Employees could contribute to the before-tax 401(k), a Roth 401(k), or both in nearly all of the plans analyzed. Additionally, half of the plans also allow after-tax contributions.
Roth 401(k) Impact on After-Tax Contributions?
A question that has emerged is whether a Roth 401(k) option replaces the need for an after-tax savings feature in a plan. Approximately one-third of companies allow after-tax contributions in their 401(k) plans.
While after-tax and Roth 401(k) contributions are both made in after-tax dollars, after-tax contributions are quite different from Roth. The most significant difference is that Roth 401(k) contributions are subject to IRS Code Section 402(g) limits ($16,500 in 2010), while after-tax contributions are not. After-tax contributions are considered a viable savings vehicle for participants who have maxed out at the 402(g) limit but still want to defer additional savings (up to a total $49,000 in 2010). Additional differences include:
n After-tax monies are generally more easily accessed by participants, whereas Roth 401(k) savings are subject to more stringent hardship rules. The majority of the plans with after-tax accounts allow participants to take nonhardship withdrawals (for any reason regardless of age). On the other hand, Roth 401(k) monies can only be accessed in hardship withdrawals prior to age 59½.
n Earnings (and contributions) can be withdrawn tax-free from a qualified Roth 401(k) distribution if the account is held for at least five years and the employee is at least 59½.
Earnings attributable to after-tax contributions are subject to taxes.
Overall Participant Usage
In assessing overall participant usage of a Roth 401(k) feature, 7.4% of active workers elected to save in Roth, where available. The average Roth deferral was 6.8% of pay, with a total contribution rate (including before-tax, after-tax, and Roth) of Roth users at 10.8%.
While overall usage was 7.4% of participants, usage of a Roth 401(k) feature varied signifi- cantly by company—ranging from 4% to 22%
of participants. Most companies that saw low Roth usage either recently implemented the feature or automatically default their new hires into a before-tax option (rather than Roth).
Plans with relatively higher usage had been early adopters of Roth and/or were organiza- tions with more financially savvy populations.
It is notable that most of the early adopters were insurance, financial services, or professional
When assessing the duration of a Roth offering, overall participant usage tends to grow through years one and two, and then stabilizes after three years. The chart below shows the overall participant utilization post adoption, with 7% of workers adding one year post implementation and 15% on average three years after.
Employee Usage—Summary Facts
n 7.4% of participants make Roth 401(k) contributions when available. This varies by company.
n Usage was significantly higher among newly enrolled workers (post Roth implementation)—
nearly 13% of new participants opted for Roth.
n Younger workers are most likely to use a Roth option, with nearly 17% of participants in their 20s electing to use the feature.
n On average, Roth contributors defer a combined 10.8% of their pay to Roth, before tax, or after tax accounts in 2009—considerably higher than the average total contribution rate of the rest of the population as a whole at 8.1%.
n Half of participants who invest in Roth 401(k) also save in a before-tax account.
Percentage of Participants
Using Roth by Time Since Adoption
20%
15%
10%
5%
0%
2%
7%
9%
15% 15%
It’s typically more difficult to engage existing workers to change their savings behaviors as compared to newly enrolled participants.
Therefore, a separate analysis was performed on newly enrolled participants who joined the plan after a Roth 401(k) feature was already in place. Within this demographic, usage was substantially higher, with nearly 13% of newly enrolled workers opting to use a Roth 401(k) feature. Engaging employees as they’re making their initial decisions clearly has a strong influence on usage rates.
Usage—Participant Demographics
Younger participants are most likely to use a Roth 401(k) feature. Where available, 16.6%
of workers in their 20s elected to use a Roth 401(k) versus only 4.2% of those in their 50s.
This is consistent with the premise that younger workers will benefit more from Roth contribtions given they often have lower current tax rates (typically correlating to lower wages). In terms of salary, those earning between $60,000 and
$80,000 had the highest usage of a Roth 401(k) feature. However, considerable adoption was also seen in all income levels above $40,000.
Usage—Roth 401(k) and Before Tax Savings Behavior
Interestingly, many of the Roth contributors also made before-tax or after-tax contributions.
In fact, 54% of the Roth contributors simultane- ously contributed to before tax accounts. Where after tax contributions were available, 14%
of the Roth contributors also made after tax contributions.
Newly enrolled participants are more likely to make distinct decisions, whereas existing par- ticipants are likely to split contributions. Newer workers are more likely to use a Roth feature, and they’re also more prone to dedicate all
Percentage of Participants Using Roth by Age
Percentage of Participants Using Roth by Salary
20%
15%
10%
5%
0%
16.6%
9.4%
6.0%
4.2% 2.6%
20-29 30-39 40-49 50-59 60+
Roth Exclusivity—Participants Using Roth
100%
75%
50%
25%
0%
59%
41%
EnrolleesNew
34%
66%
46% 54%
Existing
Participants All
12%
10%
8%
6%
4%
2%
0%
4.9%
7.9%
9.9%
8.2% 7.5%
$20-39k $40-59k $60-79k $80-99k $100k+
Contributions Solely in Roth Split Contributions
contributions and savings to a Roth 401(k).
Nearly 60% of new enrollees who used the Roth feature invested all of their new contributions in a Roth 401(k), while only a third of existing participants did so.
Younger participants are also more likely to invest exclusively in a Roth account compared to older participants. Among those in their 20s, 63% invested solely in a Roth account versus only 30% of those in their 50s.
Contribution Rate—Details
Overall, the average total contribution rate of the Roth contributors was significantly higher than other plan participants. On average, Roth contributors deferred 10.8% of their pay to Roth, before-tax, or after-tax accounts in 2009—
considerably higher than the average total contribution rate of the rest of the population as a whole (8.1%).
Those who split their contributions between a Roth 401(k) and a before/after-tax account also had a higher contribution rate than those who invested solely into Roth. In fact, the average total contribution rate was 11.6%
among participants who split their contribution between Roth and before/after-tax versus 9.7% among those who contributed all monies to Roth 401(k). This held true for both new enrollees and existing participants.
Conclusion
Given its relatively short history, a Roth 401(k) option has proved beneficial to a meaningful segment of plan participants. Data shows there is genuine participant interest in and significant use of the Roth design. Further, having one may actually increase participants’ retirement savings.
The Roth feature is increasingly becoming a more prevalent 401(k) and 403(b) feature and is likely to become an inherent feature in all plans—
especially with pending legislation expanding its use.
Average Savings Rates Among Participants Using Roth
14%
12%
10%
8%
6%
4%
2%
0%
8.3%
41%
EnrolleesNew Existing
Participants All
10.2%
11.4%12.3%
9.7%
11.6%
Contributions Solely in Roth Split Contributions
About Hewitt Associates
Hewitt Associates (NYSE: HEW) provides leading organizations around the world with expert human resources consulting and outsourcing solutions to help them anticipate and solve their most complex benefits, talent, and related financial challenges. Hewitt consults with companies to design and implement a wide range of human resources, retirement, investment management, health management, compensation, and talent management strategies. As a leading outsourcing provider, Hewitt administers health care, retirement, payroll, and other HR programs to millions of employees, their families, and retirees. With a history of exceptional client service since
Considerations to Make a Roth 401(k) Implementation a Success
n Communicate with employees on the introduction of a Roth 401(k) using multiple channels, including e-mail, postal mail, employee newsletters, internal/benefit Web sites, and workshops.
n Educate employees about Roth 401(k) contributions. For example, provide a comparison of Roth 401(k) and before-tax 401(k) contributions, share examples of who might want to make Roth 401(k) contributions, explain the benefit of tax diversification, and address frequently asked questions about a Roth 401(k).
n Provide modeling tools to help employees make their savings decision. Modeling tools can help employees understand the impact to their paycheck and future retirement savings.
