Roth Accounts Can Improve Retirement Outcomes

The addition of a Roth savings feature to defined contribution plans is becoming more popular.

The 2014 PLANSPONSOR Defined Contribution Survey finds that 52.4% of plan sponsors/respondents offer a Roth account in their plans and nearly 61% of the largest plans (those with greater than $1 billion in assets) offer a Roth account. In addition, Rob Austin, director of retirement research with Aon Hewitt says Aon Hewitt research found 50% of employers surveyed in 2013 offered a Roth account, compared with only 11% in 2007, and the Vanguard Center for Retirement Research finds that for large plans administered by Vanguard, 52% offered a Roth account in 2013, compared with 46% in 2011 and 37% in 2009. Vanguard’s findings show that for small plans, the percentage of those offering Roth plans is even higher (73%).

“The adoption of Roth features is definitely rising,” Jean Young, senior analyst, Vanguard Center for Retirement Research, tells PLANADVISER. Roth accounts appeal to a broad segment of employees, she says, offering advantages to employees from a tax standpoint. Young, who is based in Valley Forge, Pennsylvania, explains that because taxes on Roth contributions are now instead of later, this helps to alleviate some of the worry that employees may have about what their tax rates will be once they retire and during their years in retirement.

Austin agrees that tax considerations are an important part of why Roth accounts appeal to employees. Austin, who is based in Charlotte, North Carolina, tells PLANADVISER, “What it comes down to is that if a person believes that their taxes are going to be higher in retirement than they are right now, then people prefer to pay the taxes now.” He notes factors that can play a role in determining an employee’s tax bracket during retirement include state income tax and cost of living where an employee resides during his or her retirement years.

“From the employer standpoint, if there’s demand by employees for a Roth feature, then there’s no reason not to have it,” says Austin. From an informational standpoint, he says, explaining the difference between Roth contributions and non-Roth contributions to employees is no less confusing than explaining the difference between investing in one stock versus another. “Giving employees additional options like Roth accounts adds value to your company’s retirement plan,” says Austin.

The statutory limit for employee deferrals (the 402(g) limit)—currently $17,500—applies whether deferrals are pre-tax, after-tax or both. Austin explains that employees can use all of that amount on pre-tax contributions or all of that amount on Roth contributions, or a combination of both.

As to whether Roth accounts can help improve employees’ retirement readiness, Young says, “If an employee makes the same deferral amounts with Roth as they would with a pre-tax account, upon retirement, more assets will be available.” This is because the tax has already been paid on the Roth contributions and any appreciation of the account is not subject to taxation, she explains.

Austin also sees Roth accounts as a means of boosting the retirement readiness of employees. “When Roth is available to and used by employees as part of their retirement plan, people tend to save more,” he says. More specifically, he cites Aon Hewitt research that for those saving via a Roth account, the average deferral rate is 10.2% versus 7.7% for those using a non-Roth account.

DC Roth Accounts and Health Care in Retirement

The tax advantages of Roth accounts can also impact decisions concerning health care during retirement, according to Ron Mastrogiovanni, CEO of HealthView Services.

The Danvers, Massachusetts-based Mastrogiovanni tells PLANADVISER, “Employers are doing whatever they can to ensure that their employees are ready for retirement and that includes health care. Roth accounts can impact health care costs during retirement in that the taxes paid on Roth contributions don’t fall under MAGI, or modified adjusted gross income, which is used to determine Medicare premiums, parts B and D, paid during retirement.” He adds that employers want their employees to retire when they want to and to avoid having to work an extra number of years to pay for health care costs. So, explaining to employees the benefits of using a Roth account, when it comes to Medicare premiums, is important.

“Inflation will eventually translate into higher earnings for employees. Social Security benefits will grow slowly and will be included in the means testing calculation under MAGI. And savings will eventually be counted as earned income,” says Mastrogiovanni. The result will be that more retirees will end up in high income brackets and thus pay more for Medicare, he says, unless they can use after-tax retirement vehicles such as Roth accounts to lower their income bracket. “With Roth, employees are paying taxes now on their account balance and know they are not going to get hit with it later,” he adds.

Who’s Using Roth Accounts?

Austin says younger employees are using Roth accounts the most, since they are dealing with a longer time horizon. He cites Aon Hewitt research that 17.2% of those between the ages 20 and 29 use Roth accounts compared with only 8.9% of those between ages 50 and 59, and 5.7% for those age 60 and above.

Young agrees that younger employees, as well as those having a relatively short tenure with the company, are more likely to use Roth accounts. She cites Vanguard research that for those with one year or less of tenure, 20% of this group use a Roth account, while those with between one and three years of tenure have a similar usage rate of 17%.

The type of industry in which an employee works also seems to play a role in usage rates for Roth accounts, according to Young. Again citing Vanguard data, Young says the top five industries for employees using Roth accounts include: business, professional and nonprofit (17%); agriculture, mining and construction (16%); wholesale and retail trade (16%); education and health (16%); and media, entertainment and leisure (13%).