Roth 401(k)s could get a boost from the SECURE Act

The death of the stretch IRA could lead to wider use of a savings feature that's often neglected in company-sponsored retirement plans: the Roth 401(k).

While most employers that offer 401(k)s include a Roth option, less than a quarter of participants opt for a Roth when it's made available. Like their individual retirement account counterparts, Roth 401(k)s can yield future tax savings for highly compensated workers or others who anticipate facing higher tax liabilities in their retirement years.

The recently passed SECURE Act did away with stretch provisions that allowed young beneficiaries to gradually take distributions from inherited IRAs over the course of their lives. Now, many beneficiaries must take distributions within 10 years, which can lead to higher tax consequences in a short time frame.

“The elimination of the stretch IRA is going to have more [retirement plan] advisers talking with their participants about what they need to be thinking about,” said Tom Foster, a former national spokesman for MassMutual who's now managing director of the speakers bureau at The Retirement Advisor University.

“The vast majority of employees are clueless about what they should be doing with the retirement dollars,” Mr. Foster said.

Roth 401(k)s have the same 10-year distribution limit for beneficiaries, but they have the potential benefit of reducing tax liability, he said. And Roth 401(k)s have the same annual limits on contributions and catch-up contributions as traditional 401(k)s, currently set at $19,500 and $6,500, respectively.

Mr. Foster said 401(k) savers can put all of their contributions in a Roth 401(k) or split their contributions between traditional and Roth accounts.

Given the future tax consequences, advisers can help guide clients' decisions about whether to save in one bucket or in two. Advisers should be working in conjunction with employers to help educate participants about their options, Mr. Foster said.

“It really depends on what the person’s lifestyle is and if they’re going to change their lifestyle in retirement,” he said.

Even so, the tax rates that passed as part of the Tax Cuts and Job Act expire in 2025, which leads to uncertainty about which strategy will pay off most, Mr. Foster said. “Who knows what the taxes are going to be? And who knows what future legislation will be?”

One adviser uses health savings accounts as a way to get sponsors and participants to give more consideration to Roth 401(k)s.

“You’re going to have this medical expense throughout your lifetime,” said Jamie Greenleaf, principal at Cafaro Greenleaf. “You can take out the same amount from your 401(k) … and you’re going to pay higher premiums for Medicare than the person who took it out of the Roth.”

That discussion has led to wider Roth 401(k) use in the plans she advises, Ms. Greenleaf said. “It’s really resonating with people.”

Statistics on the use of Roth 401(k)s vary considerably, though it appears that most employers that offer traditional versions of the plans also provide a Roth option.

Seventy-one percent of the plans in Vanguard’s record-keeping business offered Roth 401(k)s in 2018, up from 56% in 2014, according to Vanguard’s most recent How America Saves report. But only 11% of participants with access to such plans opted for them in 2018, Vanguard said.

However, data from the Plan Sponsor Council of America show that 23% of people in plans with Roth options participated in them in 2018, up from just over 19% in 2014.

The Roth 401(k) option has become ubiquitous, as retirement plan record keepers now have the technological capabilities that allow them to administer Roth 401(k)s, something that was less common a few years ago, said Jana Steele, senior vice president in the defined-contribution consulting group at Callan.

And more employers have gotten a push to add them because recently hired workers often had Roth 401(k)s with their prior employers, Ms. Steele said.

“You can’t roll in Roth balances [to a new plan] unless you have a Roth feature – so that is a strong driver of these [employers] being able to offer it,” she said.

Younger employees participate in Roth 401(k)s at higher rates of as much as 25%, as new hires are more likely to sign up for them, Ms. Steele said.

More than anything, what keeps usage low is that employers almost never set Roth 401(k)s as the default account type for participants they automatically enroll, she said. That is the result of IRS guidance that includes an example of traditional 401(k)s being used as the default.

“We automatically enroll everybody into pretax [accounts], and that is probably not the best way to enroll some people,” Ms. Greenleaf said.

Roth 401(k)s are “permitted under the Pension Protection Act of 2006, but none of the examples the IRS provided have mentioned Roth as an automatic source,” Ms. Steele said.

Until the IRS provides a clear example for plan sponsors, “it’s going to be a slow pick-up rate, simply because participants don’t tend to take action,” she said.