Don’t forget tax diversification
Advisers, plan sponsors and investment gurus preach diversification as a critical factor in investor success. To maximize the return on your portfolio, the argument goes, it’s crucial to maintain a proper asset allocation aligned with one’s risk tolerance.
But in emphasizing diversification only in terms of asset classes and sectors, advisers may be downplaying another important aspect of a well-diversified investment portfolio: tax diversification through pretax 401(k) and Roth 401(k) contributions.
Choosing the right, tax-smart combination of sources for retirement assets is an important factor in long-term investing success. In addition to current age and future earnings potential, factors such as current versus future tax rates, company matches and assets outside of a retirement plan need to be considered when determining whether to contribute income pretax into a 401(k), or pay taxes upfront in a Roth 401(k).
Educating plan sponsors on the benefits of tax diversification and helping them understand the different needs of employees participating in a company retirement plan also has business benefits. Retirement plan advisers we work with note that this value-add helps them build deeper client relationships with plan sponsors — and it can help participants achieve retirement success.
One critical step in helping plan sponsors unlock the benefits of tax diversification is to establish automatic enrollment plans that utilize both pretax and Roth contributions for newly hired workers. According to Aon Hewitt’s “Trends & Experience in Defined Contribution Plans” study, about half of all plan sponsors surveyed allowed Roth contributions, up from just 11% in 2007. The same study found 59% of 401(k) plans have automatic enrollment for participants. But too often Roth contribution options are not used with automatic enrollment.
Automatic enrollment boosts plan participation: The average participation rate in 401(k) auto-enrollment plans is around 85%, while companies without it have participation rates 20 percentage points lower. It’s likely plan sponsors would see similar participation gains with automatic Roth contributions.
Taking a tax diversification approach also helps advisers and plan sponsors more closely match retirement savings vehicles with the needs of different employee segments. Looking at the macro level of an employee base, different demographic groups will benefit from different money sources. In our research, we have found:
• Younger workers are adopting Roth options at roughly twice the rate of workers in their 50s, according to the Aon Hewitt study. Because they are typically in lower tax brackets, paying taxes now allows contributions to grow tax free for many years until retirement, when most will be in a higher tax bracket.
• Highly compensated employees will be in a high tax bracket, and unless they have sufficient retirement savings to generate an equal amount of income in retirement, they are better off taking a tax deduction now and putting pretax retirement savings into a defined contribution plan.
• Older workers approaching retirement are likely also better off contributing pretax savings because when they enter retirement, their income and tax bracket will probably go down. Therefore, they are better off taking the larger deduction today.
The decision of whether or not to contribute pretax or Roth to a 401(k) hinges on forecasts of current versus future tax rates. The challenge with trying to forecast future tax rates is that many factors can cause them to change, including:
• Life events, such as marriage, having children or divorce
• Changes in one’s financial situation, such as a job or salary change or an inheritance
• Governmental changes to tax rules, such as raising or lowering tax rates, changing income brackets or changing tax treatment of distributions in retirement
Since many of these events are impossible to predict, the best option is to diversify and make both pre- and after-tax contributions to best prepare for future uncertainty.
Making it easy to diversify retirement money sources is also critical because of the overwhelming behavioral bias that inertia plays in investing. Most participants are unlikely to switch from pretax contributions to Roth to achieve tax diversification, so we have begun to educate advisers and plan sponsors on the benefit of auto-enrollment in both money sources.
It’s a surefire way to ensure that not all nest eggs are in one tax basket.
Located in Denver, Colorado with a satellite office in Metairie, LA, LT Trust is a low-cost 401(k), open architecture 401(k) recordkeeper that helps financial advisors and plan sponsors to achieve retirement readiness. With a focus on small business 401(k)s, LT Trust is on a mission to provide cost-efficient retirement plans without compromising quality or customer service.