Roth Tax Treatment Remains a Mystery for Many

Survey data covering some 1,000 plan participants shows Roth savings features remain poorly understood and underutilized. 

The latest research from Cerulli Associates suggests that two out of three retirement savers have either no understanding or a mistaken understanding of Roth 401(k) contributions.

According to Jessica Sclafani, associate director at Cerulli, the finding is particularly timely given the potential “Rothification of the defined contribution (DC) market through tax reform.”

She points out that the approximately 1,000 DC plan participants who took the Cerulli survey were asked to select the descriptions that best detailed Roth contributions: “Only one-third of participants correctly identified the benefits of Roth contributions—that contributions are made after-tax, and that money grows tax-free with no taxes paid when withdrawn at retirement.”

Sclafani fits squarely in the camp of believers holding that traditional 401(k) and individual retirement account (IRA) tax deductions are crucial tools by which the federal government encourages Americans to spend or save.

“As it relates to retirement, the current tax code allows taxpayers to deduct retirement savings and delay paying taxes on traditional accounts—as opposed to Roth—until the savings are withdrawn, thereby encouraging individuals to build a nest egg to fund their retirement,” she explains. Simply put, this incentive would no longer exist if tax reform succeeds in Rothifying the DC market. “This could, in turn, dramatically change Americans’ retirement savings behavior.”

Important to note, there are also some emerging proponents of the “Rothification” of DC plans, including NerdWallet’s Arielle O’Shea, co-author of “Roths Top Traditional IRAs by up to Six Figures in Retirement Savings Analysis.” As the title of the research indicates, O’Shea argues that for most savers at largely all income levels, utilizing a Roth IRA can generate significantly more retirement wealth compared with a traditional individual retirement account. Outlining the research results for PLANADVISER, O’Shea suggested she and her colleagues were surprised by just how well the Roth approach performed in the comparative analysis. In fact, using a Roth individual retirement account seems to net investors many more retirement dollars in most cases, she observes, “and the difference is well over $100,000 in the vast majority of tax scenarios.” The performance premium of the Roth approach comes in large part from the fact that, in this exercise, the savers are in effect investing more of their present income in nominal dollar terms up front to make up for the fact that they are also paying taxes up front. 

Whether or not Roth accounts tend to perform better over the long-term savings lifecycles of retirement plan participants, Cerulli warns that the lack of understanding of Roth contributions will cause “behavioral challenges associated with taxable contributions and the loss of the immediate tax benefit.”

Sclafani goes on to suggest there are some “important counterinitiatives” that recordkeepers and retirement plan consultants can consider to get in front of tax reform and the potential threat it poses in terms of reducing DC plan contributions. These include “implementing the switch to a Roth system on a non-elective basis for participants, emphasizing the power of an employer matching contribution within the context of a Roth system, and framing a tax break as a salary raise and an opportunity to increase retirement plan deferrals,” she says.

These findings and more are presented in the third quarter 2017 issue of The Cerulli Edge, U.S. Retirement Edition. Information about obtaining Cerulli research is available here