Roth 401(k) — The Overlooked Retirement Investment Tool

Only 11 percent of employers take advantage of Roth 401(k) options. Why this is a missed opportunity for employees to maximize their retirement income.

A Roth 401(k) can be a great way for employees to save for retirement, but few employees take advantage of the opportunity. According to Fidelity Investments, the largest provider of 401(k) investments, about seven in 10 companies offer a Roth option, but only 11 percent of employees take advantage of this type of retirement plan.

Most people are familiar with the traditional employer-sponsored 401(k) retirement plan. Employees may contribute up to $19,500 in 2020 through automatic payroll deductions of pre-tax dollars to a 401(k). Employees who are 50 or older may contribute up to $26,000. Employers usually match contributions up to a certain percent.

A Roth is similar but differs in that employees contribute after-tax dollars. Yes, their contributions are taxed upfront, but they can make withdrawals during retirement tax free as long as they are at least 59½ years old and have held the account at least five years. This helps them minimize their tax bill when they’re older and presumably have less income. For instance, when a retiree takes a dollar out of a Roth account, they keep the entire amount. When they take a dollar out of a traditional 401(k), they keep only the remainder after paying taxes on the distribution.

Both traditional 401(k)s and traditional IRAs require individuals to begin taking required minimum distributions at age 72. However, if your employee isn’t ready to take distributions, they can roll the balance directly into a Roth IRA. The Roth IRA also doesn’t require minimum distributions.

Roth 401(k) and Roth IRAs are similar, except that there’s no income limit regarding who can participate in a Roth 401(k). In addition, there is no required minimum distribution at age 72 (70½ prior to Jan. 1, 2020) with a Roth IRA.

A Healthy Mix

Many financial advisors recommend taking advantage of both types of retirement savings plans and tap the accounts that allow tax-free withdrawals first — such as Roth accounts and brokerage accounts.

Employees who contribute the maximum allowed to either account each year will yield the same amount of money in retirement. The traditional 401(k) balance would be reduced by their tax rate in retirement, and the Roth 401(k) balance would remain whole.

However, one of the biggest reasons employees should choose to contribute to a Roth 401(k) is if their tax rate is low now and they expect it to be higher in retirement. When approached that way, they won’t pay taxes at that higher rate when they take qualified distributions in retirement. Since their income and standard of living likely will increase over time — particularly for young employees — they will probably want to draw more money in retirement than they’re earning now. However, if their tax rate is higher now than they expect it to be in retirement, then contributions to a 401(k) would likely be the better investment.