As a financial adviser, I am often asked the question: “What should I be investing in?” The situation usually differs, whether it’s a stranger or a friend, at work or at a social gathering—but the question remains the same. I have to laugh, as I know this question usually translates into a request for a hot stock tip. The question remains the same, and so does my answer. Investing is about the prudent allocation of capital and strategy to meet an end goal. Opportunity can be taken advantage of, but that is only one piece of the puzzle.
As tax season is upon us, I feel that it’s relevant to discuss a growing trend in the prudent capital allocation puzzle: the Roth 401(k). The Plan Sponsor Attitudes 2015 survey conducted by Fidelity found that 33% of plan sponsors surveyed added a Roth option to their organization’s retirement plan in 2015. Many of the plans that we consult have requested or implemented the Roth option as well. But we’ve found that while plan sponsors are open to the addition, most participants don’t understand the benefit and are not taking advantage of it.
Here are the key facts: the Roth 401(k) option does not have the income limitations a Roth IRA does, a higher amount can be saved as compared to a Roth IRA, and the money can be withdrawn tax free in retirement. Not to mention that a participant can roll their Roth 401(k) into a Roth IRA in retirement and avoid having to take Required Minimum Distributions (RMDs).
This makes for a compelling case for the Roth 401(k). But prudent capital allocation has to look at the negative aspects as well. Roth 401(k) contributions are taxed today, removing the current tax benefit of a traditional 401(k). Typically, the Roth option was recommended to younger investors who expected to be in a higher tax bracket later in life. Contribute to a Roth today and a traditional vehicle later when taxes are more of a burden. Another aspect to consider is that employer contributions are still made with pre-tax dollars, meaning that a participant that utilizes the Roth option would have two accounts, one with pre-tax and one with post-tax dollars. The Roth option adds a level of complexity to the retirement equation.
Quote"View the Roth as a vehicle to hedge against future tax risk and RMDs."
So, when is the appropriate time to use the Roth option?
View the Roth as a vehicle to hedge against future tax risk and RMDs. There’s the potential to take some upside off the table—that is, that future tax rates will be lower. However, just as farmers sell futures contracts to hedge the price of their crop, a Roth locks in a tax rate today. Avoiding RMDs will allow participants to leave a tax-free vehicle to their heirs (if non-spouse, they will have to take RMDs). Every tool has a role, and for some participants, a Roth account doesn’t make sense. For others, the Roth option is the perfect piece to complete their prudent allocation of capital.
This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.
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