Should you use the Roth pension plan option?

We’ve had Roth options in 401(k) plans for a while now, and Roth IRAs even longer. This has allowed people to discover how Roths can provide savings benefits for retirement and other financial needs.

Up until now, the Roth option has usually only been viewed from the perspective of old-age provision.

“The Roth IRA can pay off in retirement because it gives you a tax-free source of income,” says Herman (Tommy) Thompson, Jr., a financial planner at Innovative Financial Group in Atlanta. “The traditional 401(k) and traditional IRA payout right now. Conventional contributions receive a federal and state tax deduction in the current year, making saving easier. The Roth gets no tax deduction. Additionally, some states (like Georgia) have rules that reduce or eliminate the state tax on pension distributions. The Roth 401(k) and Roth IRA just aren’t that attractive in those states.”

Deciding between using a traditional tax-deferred retirement vehicle and its Roth counterpart might seem complicated, but the math is simple.

“If tax brackets remain constant over a long period of time, the after-tax assets available for distribution under a Roth IRA and a traditional IRA are identical,” said Marcia S. Wagner, president/founder of The Wagner Law Group in Boston. “A traditional deductible IRA performs better than a Roth IRA if the individual’s tax rate at the time of distribution is lower than it was during the contribution phase.”

America has been in a low tax environment for a number of years. Many believe this will not last. The math tells you that the Roth should be the preferred retirement savings alternative. However, there are very good reasons why fewer people than expected are using Roths.

The most obvious reason is that they can’t.

“Married couples who apply together often don’t qualify because they exceed income limits ($214,000 in 2022),” said Daniel G. Dolan, director at TFB Advisors, LLC in Overland Park, Kansas. “Roth 401(k)s have no income restrictions and are now available in 70% of employer-sponsored plans. However, only 18% of participants contribute after-tax dollars to their 401(k). As a newer and less understood option, it is far from being used.”

However, there’s also an obvious reason why you don’t see as many employees using Roth 401(k) plans.

“Plans that use automatic pre-tax registration will typically see lower Roth usage,” said Kit Gleason, VP/Senior Relationship Manager, First Bank & Trust, Sioux Falls, South Dakota. “The feature overcomes participant inertia when it comes to making the savings decision, but the same participant inertia applies when it comes to making the pre-tax vs. Roth choice.”

Forgoing the tax-advantaged alternative represents an outdated mindset on the part of those designing 401(k) plans. Today’s employee demographics challenge this ongoing strategy.

Jack Towarnicky, Of Counsel at Koehler Fitzgerald, LLC in Powell, Ohio, says, “More than 95% of 401(k) plans with automatic features charge employees pre-tax contributions, even though: 1) most new hires are in as low income tax brackets, how they will experience them during their working career; 2) most non-participants (if you “backward reverse”) may be in as low an income tax bracket as they will ever see for the rest of their lives; and, perhaps most importantly, 3) the average tenure of employment for American workers remains less than five years, so if they separate before age 55 (or age 59/2), a pre-tax contribution split is not trivial would be federal and state income tax rates, but also possibly on a 10% consumption tax on the advance.”

Many plans have yet to add in-plan Roth conversion capabilities. Towarnicky attributes this to the fact that “business leaders, particularly those living in states with no income taxes or where marginal state income tax rates are low, have not considered the value of using a Roth.”

Towarnicky suggests four reasons why adding a Roth option might make sense:

  • Ability to take advantage of current low marginal income tax rates.
  • Switching to Roth IRA avoids the application of required minimum distribution rules.
  • For an executive in a 33% marginal income tax bracket contributing at the regular 402(g) and 414(v) limits (that would be $27,000) in 2022, the Roth-based contribution would be the equivalent of one dollar amount Contribution of $40,300 on a pre-tax basis.
  • Post-retirement distributions from Roth funds do not increase the modified adjusted gross income (MAGI) for the income-related monthly adjustment account (IRMAA) for Medicare Part B and Part D premium purposes.

Still, retirees just don’t access it, even when the Roth option is available (whether through a 401(k) or the IRA). In part, especially with older savers who are now inculcated in tax saving as a priority, the Roth simply doesn’t offer what they’re looking for.

Retirement savers are drawn to “instant gratification,” says RL “Dick” Billings, senior document and compliance specialist for PCS Retirement in Jefferson, South Dakota. “You can better understand tax exclusion in advance, but not income exclusion many years later. Roths are generally best for young people, but when you think about the value of such an income exclusion 40 years from now, it’s difficult to quantify.”

Assuming rising tax rates, the Roth variant makes the most sense. Still, people like the feeling of deferring taxes now.

“Many people avoid a Roth option even though they qualify for one because contributing to a traditional option helps reduce taxable income, which can help save a person money when their tax bill is due.” , says Erik Wright, owner of New Horizon Home Buyers in Chattanooga, Tennessee.

“This is a fairly short-sighted approach that can result in a portfolio being overweighted toward tax-advantaged investments over the long term,” said Ryan McKeown, senior vice president financial advisor at Wealth Enhancement Group in Mankato, Minnesota. “A lot of people don’t even know they have a Roth 401(k) option in their plan. It’s an educational issue.”

It’s important to realize that short-term circumstances can make it impossible to make the long-term choice.

“With so many workers living paycheck to paycheck,” says Kenneth Dean, senior director of financial planning at Winthrop Wealth in Boston, “they prefer the tax savings today to funding the Roth option with post-tax contributions because leaving them less for everyday livelihood.”

There are many good reasons to use a Roth retirement plan. There are also situations where it makes sense to use a tax-advantaged retirement account instead. Which choice suits your circumstances best?

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