Roth 401(k), the unsung hero of retirement plans

December 14, 2018

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Since the inception of the Roth 401(k) option in 2006, the percentage of 401(k) plans that allow Roth deferrals has grown considerably. From 2013 to 2017, the percentage of plans offering Roth 401(k) in Vanguard's full-service business has risen from 52% to 68%.1

However, the percentage of participants making Roth deferrals in these plans has remained the same or fallen in certain years. For example, 13% of participants made Roth deferrals in 2016, but that number dropped to 12% by the end of 2017.

Why the lack of Roth uptake at the participant level?

Ironically, the increased adoption of automatic enrollment is one contributing factor. As of 2017, 46% of all Vanguard plans, and 65% of plans with more than 5,000 participants, have adopted automatic enrollment. While participants are participating at higher levels than they would without autoenrollment, which is a positive development, most plans default participants to pre-tax deferrals at a specified rate.

Automatic enrollment is an extremely effective plan design that relies on, among other things, certain behavioral outcomes to achieve greater retirement savings. Among the most important behavioral factors is the power of inertia. Faced with an array of choices and competing priorities, many employees will be content to stick with the default choices provided by their employer. Inertia helps drive participation rates and savings levels, especially in automatic enrollment plans, but that same inertia affects the type of deferral contributions that are made by participants. Because the vast majority of plans default savings into a pre-tax rather than Roth source, inertia keeps most assets in that pre-tax source.

While there is little doubt that participants still stand to benefit over the long run from being automatically enrolled in the plan, they could be missing out by not making Roth deferrals. The same opportunities that existed when Roth was introduced in 2006 remain today:

  • For all employees: The option of tax diversification. We cannot be sure of a lower tax bracket in retirement, so holding both pre-tax and Roth mitigates that risk.
  • For low- and middle-income employees: Paying income tax at lower rates.
  • For participants who are better prepared for retirement: The potential to reduce the percentage of savings exposed to potentially high tax rates. These participants generally save at above-average rates (above 6% median) and receive match and/or other defined contribution benefits or are possibly also covered by a defined benefit pension plan. These participants are likely to maintain their current income—and tax bracket—in retirement and are at risk of exposing large pre-tax balances to a tax increase.
  • Roth savings can allow for additional spending flexibility in retirement: Participants who make a large purchase using Roth assets will not trigger a higher tax liability. Further, if they don't spend down Roth assets in retirement, they will be leaving their beneficiaries a tax-free asset.

Next steps

The potential impact a Roth 401(k) feature can have for participants is often underappreciated. If you're interested in adding the Roth 401(k) option to your plan, please contact your Vanguard representative. For your participants who want to learn more about the tax diversification benefits of making Roth 401(k) contributions, we recommend the "What can Roth contributions do for me?" online lesson through our secure participant website.

1 Source: Vanguard.


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