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The share of employers allowing Roth 401 (k) savings jumped last year, giving more workers access to the financial benefits that come with these contributions.
A Roth is a type of after-tax account. Workers pay taxes up front on 401 (k) savings, but investment growth and account withdrawals in retirement are tax-exempt. This differs from traditional before-tax savings, where workers get tax relief up front but pay later.
Not all plans allow workers to save on a Roth account. The percentage of 401 (k) plans offering the option rose to 86% in 2020, from 75% in 2019 and 49% a decade ago, according to the Plan Sponsor Council of America, a trading group.
“It’s steadily increasing,” said Hattie Greenan, the group’s research director.
This is likely because awareness of the benefits of Roth accounts has grown over time among employers and employees, who can pressure companies to add the option, Greenan said.
The profile of the Roth option may have risen again this year, as Democratic lawmakers weighed the rules to restrict the use of these accounts as tax shelters for the wealthy. A ProPublica article in June described how billionaires like PayPal co-founder Peter Thiel have used Roth accounts to accumulate vast wealth.
Larger employers are the most likely to offer the option – about 91% of 401 (k) plans with more than 5,000 savers have a Roth feature.
Benefits of Roth
According to financial advisers, Roth 401 (k) contributions make sense to investors who are likely in a lower tax bracket than they were when they retire.
This is because they would accumulate a bigger nest egg by paying taxes now at a lower tax rate.
It’s impossible to know what your tax rate will be or your exact financial situation in retirement, which could take decades. However, there are a few guiding principles for Roth.
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For example, Roth accounts will generally make sense to young people, especially those new to the workforce, who are likely to have their highest paying years ahead of them. These contributions and any growth in investments would then be exempt from tax for decades. (An important note: Investment growth is only exempt from tax for withdrawals after 59½ years.)
Some may avoid Roth savings because they assume both their spending and their tax bracket will go down when they retire. But that doesn’t always happen, according to financial advisers.
Roth accounts also have benefits beyond tax savings.
For example, savers who transfer their Roth 401 (k) money to a Roth individual retirement account do not need to take the required minimum distributions. The same is not true for traditional pre-tax accounts; retirees must withdraw funds from their pre-tax accounts from age 72, even if they do not need them.
Roth savings can also help reduce annual Medicare Part B premiums, which are based on taxable income. Since Roth withdrawals are considered tax-free income, strategically withdrawing money from Roth accounts can prevent one’s income from exceeding certain Medicare thresholds.
Some advisers recommend earmarking both pre-tax and Roth 401 (k) savings, regardless of age, as a hedging and diversification strategy.
Investor use of Roth 401 (k) savings has increased in recent years with greater availability. About 26% of workers who save in their 401 (k) plan used the Roth option in 2020, up from 18% in 2016, according to the Plan Sponsor Council of America.
“Usage tends to lag a bit behind availability as companies educate about it,” Greenan said.
There are several reasons why people may not make Roth contributions.
Automatic employee enrollment in 401 (k) plans has become popular – 62% of plans use something called “auto enrollment”. Often, companies don’t set Roth savings as the default savings option, which means auto-enrolled employees would have to proactively change their allocation.
Additionally, employers that match 401 (k) savings do so in the pre-tax savings compartment. High incomes may also mistakenly think that there are income limits for contributing to a Roth 401 (k), as is the case with a Roth individual retirement account.