When it comes to company-sponsored retirement accounts, most employers now offer two options: the traditional 401(k) and a Roth 401(k).
The Roth 401(k), like a Roth IRA, lets you build a nest egg that grows tax-free, but relatively few workers take advantage of this opportunity.
The Roth 401(k) was started 13 year ago. Nearly 75 percent of corporate retirement accounts now offer the Roth option, but participation remains low — only 7.6 percent last year, according to a recent market analysis by T. Rowe Price.
Personal finance experts contacted by NBC News BETTER suggest a few possible reasons for this:
- Many new hires are automatically enrolled in a traditional 401(k).
- Some employees may not know about the Roth option or why it might make sense for them.
- The lure of a tax break now is more powerful than the long-term goal of having enough retirement savings.
Greg McBride, chief financial analyst at Bankrate.com, recommends more employees take advantage of the Roth 401(k).
“Once you understand the benefits, it makes a really compelling option, especially if you’re young and you want to accumulate years of compounding on money that you can withdraw tax-free in retirement,” McBride said. “Every $1,000 you save in your 20s can be $15,000 by the time you retire. With a Roth 401(k) you get to keep that entire sum, instead of giving a big chunk of it to Uncle Sam.”
Bankrate’s 401(k)/Roth 401(k) calculator lets you see how your money will grow over time.
The 401(k) vs. The Roth 401(k)
With the traditional 401(k), contributions are pre-tax money — taken out of your paycheck before your wages are taxed. This reduces your adjustable gross income for the year and therefore the income taxes you pay. You will be taxed as you make withdrawals, but it’s assumed that you’ll be in a lower tax bracket when you retire.
The Roth 401(k) flips this model on its head. It’s funded with wages that have already been taxed, so withdrawals are free in retirement.
Current contribution limits are the same for both types of 401(k) accounts: $19,000 per year (not including employer match) or $25,000 for workers 50 and older.
Make the maximum contribution to either type of account each year and you’ll have the same pot of money in retirement, but the Roth will be more valuable, as Arielle O’Shea, investing and retirement specialist at NerdWallet, noted in a recent blogpost.
“$100,000 in a Roth 401(k) is $100,000, while $100,000 in a traditional 401(k) is $100,000 less the taxes you’ll owe on each distribution,” O’Shea wrote.
There are no income limitations on a Roth 401(k), “making it an attractive option for high-earners whose salaries might disqualify them from contributing to an IRA,” noted Kiplinger.com in a recent report.
Does a Roth 401(k) make sense for you?
If it’s early in your career and you’re at a lower salary than you might be in the future, then it may be a good time to consider Roth contributions.
“It doesn’t reduce your taxable income today, but the idea of tax-free income in retirement, when you’re actually going to use the money, might be more of a tax benefit,” said Judith Ward, a senior financial planner at T. Rowe Price. “On the flip side: If you’re at a high tax bracket today and you think your tax bracket is going to be lower in retirement, then pre-tax contributions into a traditional 401(k) might make more sense because you get the tax benefit now, when you need it.”
With a Roth IRA you can make withdrawals at any time without penalty. Once you’ve turned 59½ disbursements from a Roth 401(k) are tax-free and without a 10 percent penalty only after the account has been open for five years or more.
The benefits of tax diversification
No one knows what will happen to their career path and it’s impossible to predict what tax rates will be in the future. Remember, up until 1980, the top marginal tax rate averaged 78 percent.
“The Roth 401(k) lets you lock in your current tax rate, whatever it may be, whereas with a traditional 401(k) you’re essentially betting that your tax rate is going to be favorable in retirement compared to where it is now,” said Matthew Frankel, a certified financial planner who writes for the Motley Fool.
You can have both types of 401(k) accounts, as long as the combined contributions don’t exceed the total allowable limit. Any employer contributions will go into your traditional 401(k).
Financial planners like this “tax diversification” because it provides a hedge against the uncertainty of future taxes and gives you maximum flexibility when it’s time to tap into your retirement savings.
By having the different buckets to choose from — money that will be taxed and money that’s tax-free — you can literally determine, in some cases, how much of that retirement income will be taxed each year.
Frankel gives this example: Let’s assume that when you retire the first $50,000 in annual income will be taxed at 12 percent tax and anything above that at 22 percent. You need $80,000 to cover expenses.
To reduce your taxable income, you could withdraw $50,000 from your traditional 401(k) — taxed at 12 percent — and $30,000 from your Roth 401(k) — tax free. If you only had a traditional 401(k) account to tap, that last $30,000 would be taxed at 22 percent.
Having a lower adjusted gross income might also reduce your tax burden on government benefits, such as Social Security.
An estate planning tool
Tax-free money in a Roth 401(k) could be beneficial to your heirs, especially if you have a significant amount of money in that account.
Let’s say your children inherit that money when they’re still working and in their peak earning years. Additional taxable income from a traditional 401(k) could be costly. Disbursements from a Roth 401(k) would not add to their tax bill. Free money is always good!
“The only thing you need to think about is: Are you giving up some tax benefit by thinking of your heirs down the road?” Ward said. “But generally speaking, Roth money is nice to leave as an inheritance because of the tax-free nature.”
The bottom line
Financial experts agree: Check to see if your company offers the Roth savings option. If so, take the time to figure out if it should be a part of your retirement portfolio.
“Just like any personal financial decision, it’s definitely worth knowing your options and what the pros and cons of each are for you,” Frankel said.