What Employees Are Missing and How Employers Can Help Cover Subtitle 12/15 65 Medium Black by David Amendola, J.D.

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1 Cover Capturing Title the 26/29 Opportunity of 45 Roth Light 401(k) Black Contributions What Employees Are Missing and How Employers Can Help Cover Subtitle 12/15 65 Medium Black by David Amendola, J.D., Vishul Shah, FSA

2 Organizations recognize that employees don t always take advantage of solutions that improve their retirement. Better Actuaries, Better Outcomes Boosting the confidence of employees in their ability to retire remains a top objective for employers. Eighty-four percent of respondents to our most recent defined contribution (DC) plan sponsor survey* said they plan to increase their efforts to educate employees on saving and investing for retirement in the next two to three years. Organizations recognize that employees don t always take advantage of solutions that improve their retirement readiness the low use of Roth 401(k) contributions is a clear example. According to this survey, while the percentage of employers offering a Roth option has grown from 46% in 2012 to 54% today, the percentage of employees making Roth contributions remains very low at 10%. Sidestepping the opportunity to save in a Roth 401(k) account, with its unique features, can lead to regret. Here s why: Roth contributions can offer tax diversification for many retirees as they begin to take pensions, employer-match contributions from 401(k)s and other taxable income, including Social Security with its complicated tax status. Participants may be able to reduce taxes paid by effective distribution strategies. Also, unlike regular 401(k)s and Social Security, Roth 401(k) contributions are not subject to minimum distribution requirements after age 70½, if they are rolled over to a Roth Individual Retirement Account (IRA). How can DC plan sponsors help employees assess the Roth savings opportunity? Employee education is key and should focus on several critical questions, including: What are the key factors to consider when evaluating the Roth option? How much value can be derived from Roth contributions? What are the risks? When does a Roth conversion make sense? How can I use a Roth IRA to avoid the Social Security tax torpedo?

3 Capturing the Opportunity of Roth 401(k) Contributions What Employees Are Missing and How Employers Can Help Table of Contents I. Considerations for Pretax and Roth Contributions...2 II. Understanding the Value of the Roth Option... 3 III. Evaluating Retirement Planning Modelers... 5 IV. Rollover of Aftertax Contributions...7 V. Looking to the Future Capturing the Opportunity of Roth 401(k) Contributions

4 Considerations for Pretax and Roth Contributions Educational tools that describe four main factors will help employees make more informed decisions in weighing the benefits of pretax and Roth contributions: Personal income taxes. Unlike a traditional 401(k) arrangement, where contributions are made on a pretax basis and savings grow tax-deferred until distribution, Roth contributions allow employees to invest on an aftertax basis, with savings growing and distributed tax-free. The critical question to ask: Is it better to pay income taxes on contributions while working or to pay taxes upon withdrawal in retirement? The answer to this seemingly simple question can be complicated even before considering possible future tax law changes. One needs to know the marginal tax rate (the tax rate for the last dollar of taxable income) and the average or effective tax rate that would apply to distributions at retirement earnings. If the average of the marginal tax rates that would have applied to the amounts contributed on a pretax basis during employment is greater than the average or effective tax rates that apply to the amounts distributed, then pretax 401(k) contributions are probably the right move. If, instead, the tax on distributions would be greater, then the Roth option would likely be a better choice. In addition, for some, using distributions from Roth prior to age 65 may be enough to enable qualification for subsidies under the Affordable Care Act as Roth distributions are excluded from modified adjusted gross income. This presents a material annual savings opportunity if using this option before Medicare. Tax diversification during retirement. A retiree receiving income from several sources will find tax-free distributions from a Roth account provide greater diversification in any given year. This can ultimately mean a lower overall tax, beyond simply the pre- and post-tax income rates. More tax-favored funds accumulating for retirement. With tax-deferred investments, tax is owed on distributions. Therefore, a retiree receives only the aftertax portion of the contribution. If the same amount had been contributed to a Roth account, the entire account balance, including any earnings on the initial amount invested, would be available to the retiree because the taxes would have already been paid. Greater distribution flexibility. Minimum distribution requirements are the same for Roth and traditional 401(k) plans. However, if Roth contribution assets are rolled over to a Roth IRA, minimum distribution requirements apply only to non-spouse beneficiaries. The Roth IRA owner and spouse are not required to take distributions from the account during their lifetimes. 2 willistowerswatson.com

5 Understanding the Value of the Roth Option Optimizing the value of a Roth 401(k) arrangement requires contributing sufficient funds so that the amount of tax paid when contributing to the Roth account is less than the tax that would have been paid on distribution if pretax contributions had been made to a traditional 401(k) account. To illustrate the potential value of using the Roth contribution option instead of the pretax contribution option, let s consider the example of a 35-year-old, single employee currently earning $100,000 per year, and assume the following (percentages are annual rates): Inflation (Consumer Price Index [CPI]): 3% Pay growth: 3% Employer contributions: 3% nonelective contributions Pretax contributions: 8% Assumed investment return: 7% Tax status: single, standard deductions For analysis, we have used Willis Towers Watson s myfitage TM employee modeler. This modeler takes into consideration the employee s current marginal tax rate, projected retirement income from savings and Social Security, amount of projected taxes, including taxes on Social Security benefits at retirement, and health care expenditure at retirement to determine a financial independence target age (FiT Age SM ) for each option. FiT Age is the age at which an employee will reach financial independence (i.e., when the value of the employee s retirement resources exceeds the value of that employee s retirement needs). The allocation of contributions to either a pretax or Roth account can be tricky for employees because of the interplay between Social Security benefits and taxes at retirement. The following chart illustrates that complexity by comparing the employee s FiT Age based on pretax contribution versus Roth contribution at different compensation levels. As illustrated in Figure 1, under the pretax option, the employee s FiT Age is However, if the employee saved 6.0%* using the Roth option instead of the pretax option, the employee s FiT Age decreases to 67.5 while maintaining the same level of take-home pay. *8% x (1-25% marginal tax rate) Figure 1. Employees can increase their retirement readiness by using Roth 401(k) contributions FiT Age Comparison Roth vs. Pretax (3% Wage Growth/3% CPI) FiT Age ,000 35,000 40,000 45,000 50,000 55,000 60,000 65,000 Current salary 70,000 75,000 80,000 85,000 90,000 95, ,000 Pretax FiT Age Roth FiT Age 3 Capturing the Opportunity of Roth 401(k) Contributions

6 Figure 2. If employee pay increases outpace inflation, making Roth 401(k) contributions is most important for employees with incomes under $60k 71.5 FiT Age Comparison Roth vs. Pretax (4% Wage Growth/3% CPI) FiT Age ,000 35,000 40,000 45,000 50,000 55,000 60,000 65,000 70,000 75,000 80,000 85,000 90,000 95, ,000 Current salary Pretax FiT Age Roth FiT Age The employee is able to lower the FiT Age at retirement under the Roth option, as the employee would be at a lower marginal tax rate of 15% instead of 25% (same as current marginal tax rate) under the pretax option at retirement. As shown in Figure 1, savings to a pretax account under these circumstances is more beneficial to lower-paid employees than higher-paid employees. For lower-paid employees, the marginal tax rate is generally lower at retirement, as a greater portion of their Social Security benefit is not subject to tax. As a result, these employees derive a greater benefit by contributing through the pretax option as it lowers their FiT Age at retirement. Higher-paid employees who remain at the same marginal tax rate at retirement as under the pretax scenario could lower their FiT Age by saving under the Roth option, as it can potentially lower their marginal tax rate at retirement. But what happens to workers whose pay increases at a rate greater than inflation? Figure 2 illustrates the effect of pay growing at 4%, while inflation (and associated tax breakpoints) increases at 3%. The allocation of contributions to either a pretax or Roth account can be tricky for employees because of the interplay between Social Security benefits and taxes at retirement. Better Actuaries, Better Outcomes In contrast to the previous example, Figure 2 shows that if an employee s pay increases at a rate greater than inflation, it is more advantageous to make Roth contributions. 4 willistowerswatson.com

7 Evaluating Retirement Planning Modelers Many employers provide modeling tools to help employees determine how much to save for retirement and whether the Roth option is right for them. But how well do these tools account for the key considerations? To reasonably estimate marginal tax rates in retirement, the retirement planning model needs to consider: Total estimated retirement income, because the distributions that come from the 401(k) contribution about to be made will likely be on top of other income such as pensions, Social Security and other distributions Pay growth, especially in comparison to inflation Inflation and how that changes future tax brackets Marital status and how that changes future tax brackets Social Security income and how it is phased in as taxable income In general, the calculators that purport to help employees decide whether or not to invest in a Roth account require a substantial amount of sophistication on the part of the user, especially tax expertise. Most of the calculators we tested require users to enter their own estimate of their current tax rate and their estimated retirement tax rate. The least helpful models don t highlight the importance of the marginal tax rates as opposed to effective tax rates. What should employers look for in an effective retirement planning modeler? A modeler should estimate at least total retirement income and, better yet, the marginal tax rate applicable to a given level of income. The more helpful modeling tools recognize that a contribution to a Roth account made in the same amount as a contribution to a traditional 401(k) on a tax-deferred basis represents a greater retirement savings because taxes on the Roth contributions have already been paid. In addition, a well-developed modeler can be useful in deciding how much to diversify one s portfolio, as it may be valuable to have both Roth and pretax resources available in retirement. Your actuary can help you evaluate modelers and determine if the assumptions are appropriate given your workforce. It s common wisdom that younger employees may benefit from the Roth option, as they are more likely to receive promotional and merit increases that will cause their pay to grow faster than inflation, which may cause them to move into higher tax brackets. However, as illustrated in the above examples, consider someone in the 25% tax bracket (which for an individual tax filer begins at about $50,000 before deductions and exemptions). This individual s inflationadjusted pay would need to increase to about $100,000 before crossing into a higher tax bracket. Upon retirement, the employee s taxable retirement income may likely be lower than the preretirement taxable income, but not likely to be so low that the employee would drop to the lower 15% bracket. By using an effective modeler, this person would see that he or she is currently in a 25% bracket and, absent a change in tax law, can expect to be in a 25% bracket upon retirement. Therefore, a credible modeler may show that although this person is young, pretax contributions may be more beneficial than Roth contributions. myfitage Employee Modeler by Willis Towers Watson Many employers only monitor data such as participation and savings rates, and investment elections. Some employers estimate replacement ratios. These rule-of-thumb measures do not provide an accurate picture of retirement readiness and workforce risk. They do not give insight on the tax efficiency of health savings accounts and Roth 401(k), or the Social Security tax torpedo. FiT Age is a two-part program that brings together all of these insights in a clear, actionable process to drive improved behaviors and outcomes, and measure progress. 5 Capturing the Opportunity of Roth 401(k) Contributions

8 Better Actuaries, Better Outcomes Blunting the Effect of the Social Security Tax Torpedo As taxable retirement income increases, Social Security benefits are phased in as taxable income until 85% is taxed. This phasing-in, also known as the tax torpedo, causes effective marginal tax rates to increase beyond the marginal tax rates that appear in the tax code due to the inclusion of additional taxable Social Security benefits. After 85% of the Social Security benefits are subject to taxation, the effective marginal tax rates revert back to the rates that appear in the tax code. For example, a single tax filer with total income of $62,500 (including Social Security) at retirement and taxable income of $33,000 after reflecting Social Security income subject to tax, deductions and exemptions might assume he is in a 15% marginal tax bracket based on the 2015 federal tax tables. But a closer look reveals that at this level of income, less than 85% of Social Security benefits would be treated as taxable income. If this filer increased his 401(k) distributions by $1,000, this additional $1,000 would be included to determine the additional taxable portion of the Social Security benefits. As a result, he would find that the taxes would increase not by $150 (15% x $1,000), but by $ (15% x $1,850) because $850 more of the filer s Social Security benefit would be counted as taxable income, resulting in an effective marginal tax rate of 27.75%. The tax benefit received upon contribution (deferring taxation on income that would have been taxed at 15%*) becomes a 27.75% tax liability upon distribution. If the filer had instead invested some of the 401(k) funds in a Roth account that was subsequently rolled over into a Roth IRA, the filer would be able to mitigate the tax torpedo s effect by electing the distributions from the Roth IRA, as those funds do not trigger the phase-in of additional Social Security benefits as taxable income. This is additional evidence of the tax diversification benefits of a Roth account. This phasing-in, known as the tax torpedo, causes effective marginal tax rates to increase beyond the marginal tax rates that appear in the tax code. *Assumes the marginal tax rate was the same while saving. FiT Age is a two-part program that brings together all of these insights in a clear, actionable process to drive improved behaviors and outcomes, and measure progress. For employers, FiT Age is a plan-level analytics tool to measure progress and provide personalized, provocative messages for employees in order to drive behavior change. For employees, myfitage is a portal that models scenarios in terms of a financial independence target age, which is both tangible and motivational. Employees do not have to provide any information to obtain their FiT Age the first visit is based on employer-provided information and savings plans, which for most employees includes the majority of their retirement resources. FiT Age uses the right mix of media to deliver messages and reach employees effectively. By incorporating targeted messages into communication vehicles such as personalized FiT Age statements, employees are prompted to take action. For more information about FiT Age, contact your local Willis Towers Watson consultant or visit 6 willistowerswatson.com

9 Rollover of Aftertax Contributions In addition to helping employees understand how they should save for retirement via an aftertax Roth option or with a traditional pretax 401(k) plan, or a combination of both organizations can assist employees in determining whether it makes sense to save using the traditional aftertax contribution feature. Traditional aftertax contributions have generally fallen out of favor, as the Roth option has typically offered employees greater benefits. However, in 2014, the IRS simplified an employee s ability to roll over traditional aftertax contributions from a 401(k) plan directly into a Roth IRA upon termination of employment. This simplification eliminated the multistep process of first receiving a distribution of the aftertax contributions and then rolling over those funds into a Roth IRA, which required the employee to have sufficient funds to cover the 20% withholding taken from the initial distribution. Rolling over aftertax contributions into a Roth IRA allows the employee to eliminate taxes on future earnings on the rolledover amounts. While the pretax and Roth aftertax contribution options typically provide employees with greater benefits and flexibility, the recent IRS changes have made traditional aftertax contributions a potentially more attractive option than in years past. For some employees, this option could be a valuable third option for retirement savings. Looking to the Future The Roth option is woefully underutilized by employees, and many plan sponsors have yet to appreciate its value. Currently, most sponsors that provide automatic enrollment do so only for traditional pretax 401(k) contributions. To help employees understand and use Roth 401(k) contributions more, organizations can: Communicate program features and benefits clearly and regularly. Because one size does not fit all and, as shown above, the value of Roth contributions may change over time even for the same employee, segment employees and identify their needs based on life stages, life events and other characteristics. Tailor communications to these segments. Keep messages short and action-oriented. Use a more interactive approach to reach employees. In addition to traditional retirement education tools such as newsletters, account statements and online webcasts, consider using mobile apps and digital technology to engage employees. Provide effective retirement planning modelers to help employees better understand their options. Your modelers should include total estimated retirement income, pay growth, inflation, tax effects and health care costs. Implement a process to monitor employee financial well-being on an ongoing basis through plan-level analysis focused on when employees will be financially ready to retire. The Roth option presents a significant opportunity to help employees build adequate retirement savings and maximize the tax strategies that will have the greatest impact on improving their retirement readiness. Future tax law changes may bring changes to the 401(k) contribution option. However, savvy plan sponsors are taking measures to help employees better understand and use Roth 401(k) contributions effectively. 7 Capturing the Opportunity of Roth 401(k) Contributions

10 Better Actuaries, Better Outcomes With more than 1,100 credentialed actuaries in the U.S., Willis Towers Watson offers solutions to help you design, finance, operate and monitor your retirement programs. For customized guidance and innovative solutions, contact your local Willis Towers Watson consultant or visit us at willistowerswatson.com. Better Actuaries, Better Outcomes 8 willistowerswatson.com

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12 About Willis Towers Watson Willis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 39,000 employees in more than 120 countries. We design and deliver solutions that manage risk, optimize benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com. Copyright 2016 Willis Towers Watson. All rights reserved. WTW-US-16-ICP-1304 willistowerswatson.com

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