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.
There is 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 last year.
Many of the plans that we consult have requested or implemented the Roth option as well. But while plan sponsors are open to the addition, most participants don’t understand the benefit and aren’t taking advantage of it.
Here are the key facts: The Roth 401(k) option doesn’t have the income limitations that a Roth individual retirement account does, a higher amount can be saved as compared with a Roth IRA, and the money can be withdrawn tax-free in retirement. In addition, a participant can roll a Roth 401(k) into a Roth IRA during retirement and avoid having to take required minimum distributions.
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 who uses 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.
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 is the potential to take some upside off the table, that is, that future tax rates will be lower.
However, just as a farmer sells futures contracts to hedge the price of a 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.
John Ludwig is an LPL Financial adviser with and the founder of LHD Retirement in Indianapolis.
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