Should you start deferring money into a Roth 401(k) account instead of a traditional 401(k) plan? Many of you still do not have access to the Roth 401(k) plans that first became available this year. But a number of you do, and many more will next year as employers add them to their plans.
The main difference between the two types of accounts is the timing of the tax benefits.
In the traditional 401(k) plan, the benefits are front-loaded. Income taxes are deferred on the money that is put into the account, and on the earnings of the account.
With the Roth 401(k), income taxes are owed on money deferred into the Roth as though the money were received in cash by the employee. There are no taxes on the earnings of the account. When distributions are taken from the Roth 401(k) account, they generally are tax free. A little-known benefit of a Roth account is that the original contributions can be taken out tax-free at any time.
The annual contribution limit for a 401(k) does not vary. If an employer offers the Roth 401(k) option, the employee can choose to defer 100% of the year’s contributions to either the traditional or Roth account, or can split the contributions between the two in any ratio (as long as the plan allows that).
Who would benefit from using a Roth 401(k) instead of a traditional account?
Younger workers likely would benefit from a Roth. They probably are in fairly low tax brackets today. It makes a lot of sense for them to pay taxes at today’s rates, then let the earnings compound for decades. When the earnings and principal are withdrawn, they are tax free.
Highly paid workers might benefit from the Roth option. The 401(k) is their only choice for a tax-free retirement account, because income limits restrict them from using Roth IRAs. Also, their tax rates might rise in the future. If they believe that, it makes sense to pay the taxes now and take tax-free distributions in the future.
Those who expect their tax rates to rise also should use a Roth. Tax rates might be higher in retirement either because of a personal situation or because tax rates overall rise to pay for budget deficits and the government benefits that will be paid to the Baby Boomers. Again, there is a benefit to paying lower tax rates now on the contributions instead of higher rates in the future on both the contributions and the compounded earnings.
Those with substantial assets also should consider a Roth. Income from the other assets might push these people into higher tax brackets in retirement, especially considering the required distributions from a traditional 401(k). Also, after the retirement the Roth 401(k) can be rolled into a Roth IRA. The Roth IRA can be passed to heirs free of income taxes.
Someone saving to help children or grandchildren also should consider the Roth option. The ability to take tax-free distributions of principal from the Roth 401(k) is a big advantage.
Tax diversification also is a reason to use the Roth option. The tax law changes frequently. None of us really know our own future tax status or what the law will be in the future. Having a Roth account gives the individual some flexibility. The taxpayer can manage the tax burden by deciding how much to take from the different accounts each year.
The Roth IRA was one of the most exciting developments in retirement savings. The Roth 401(k) options should be equally important as more employers add the option to their plans.