Colorado PERA recently announced that it is now offering a Roth feature in its optional retirement savings accounts, the PERAPlus 401(k) and 457 Plans. PERA members whose employers have adopted the Roth option are allowed to make Roth contributions.
Named for their congressional sponsor, former Delaware Senator William Roth, these are tax-paid retirement savings accounts, meaning that contributions, whether to a Roth IRA or retirement plan account, have already been taxed as regular income. But once contributed to a Roth account, earnings grow tax-free. There are no additional tax obligations when funds are withdrawn at retirement and follow the requirements of the Roth option.
There are several notable differences between using a Roth 401(k) or 457 and a traditional plan. Traditional IRA or pre-tax retirement plan contributions are not taxable when contributed, which can lower the tax rate in the year in which contributions are made. When these savings are eventually withdrawn, taxes must be paid on both contributions and any earnings.
There are also important differences between contributions to Roth 401(k) or 457 and a Roth IRA. Employer-sponsored plans have significantly higher limits compared to IRAs. For example, total IRA contributions are limited to a combined (pre-tax and Roth) maximum of $5,500 per year ($6,500 for those age 50 and older). Retirement account contributions are limited to a current maximum contribution of $18,000 ($24,000 for those age 50 and older). Contributions to a Roth IRA are also limited based on income, whereas in a 401(k) or 457 plan, there are no income restrictions that would limit contributions.
The advantages of the Roth option may be leading to different savings behavior, particularly among younger workers. According to a report issued earlier in 2014 by Aon Hewitt, a human resource leader, of clients who participated in defined contribution plans, such as a 401(k) or 457 plan, participants using Roth options contributed significantly more of their income compared to savers who did not use a Roth option when available (10.2 percent of income compared to 7.7 percent). Participants choosing the Roth option are more likely to be younger employees and to have been with their employers for a relatively shorter period of time.
Younger participants are more likely to use a Roth contribution feature than their older counterparts. More than 17 percent of workers in their 20s chose to contribute to a Roth, versus fewer than 9 percent of those in their 50s. This may reflect the pre-tax status of contributions to a Roth account. Younger workers are more likely to have a lower marginal tax rate compared to older workers who are further along in their careers.
That being said, older participants may want to consider using a Roth account for estate planning purposes. Because everyone has unique financial planning target, PERA recommends that plan participants consult a financial planning professional, use the online investment planning tools or service, or work with a trusted Certified Public Accountant or Certified Financial Planner when determining the best way to meet their financial goals.
By offering a Roth savings option to its supplemental savings accounts, PERA may be able to tap into the interest of younger workers and encourage additional contributions from a broad range of PERA members. By further encouraging members to increase their optional savings, PERA will be strengthening public workers’ ability to be prepared for retirement.
- Younger employees have the most to gain from investing in a Roth 401(k) because their longer investment time horizon gives their contributions a longer time to compound tax free, leading the contributions to be worth more at retirement.
- Younger employees may be in a lower tax bracket than down the road when they may be earning more in their careers and paying a higher marginal tax rate. This would mean that contributions made to a Roth 401k today would be taxed at a lower rate than potential contributions made when in the future when earnings are higher.
- A T Rowe Price study of its customers investing in Roth IRAs at the end of 2013 found that investors in their 40s had almost twice as much money in Roth IRAs as they did in Traditional IRAs.
- The same study looked at how much more spendable income in retirement an investor who used a Roth IRA would have compared with an investor who used a Traditional IRA. Assuming investors retired at age 65 and contributed $1,000 into a Roth IRA or a Traditional IRA, the study found that a 25-year-old who used a Roth IRA and stayed in the same tax bracket at retirement would have nearly 20 percent more spendable income in retirement than an investor who used a Traditional IRA instead. (Assumptions included that investors were in a 25 percent tax bracket at the time of their IRA contribution and that the $250 tax deduction from the Traditional IRA was invested in a separate taxable account. Investments earned an annualized 7 percent return before retirement and 6 percent during retirement).
Because eligible employees also have the option to divide their optional retirement savings between Roth and traditional options, tax diversification is another important benefit that Roth savings could provide. Employees have the option to pay taxes on Roth contributions now, while deferring taxes on traditional contributions until they are ready to withdraw their funds. As more employers begin to make the Roth option available to their employees, greater numbers of PERA members will benefit from these choices.