You know about the 401(k), but what about the Roth 401(k)?
There鈥檚 a big employee benefit you鈥檙e probably missing out on: the Roth 401(k), sister to the standard 401(k).
Over half of employers offer both options these days,聽聽from global advisory firm Willis Towers Watson, yet less than 10 percent of employees on the receiving end are taking advantage of the Roth. That number should be higher.
The benefits of the Roth 401(k)
For some workers, particularly young ones, the Roth 401(k) isn鈥檛 just the sister to the 401(k), it鈥檚 Cinderella: It imposes聽聽tax treatment on the standard version, which means contributions aren鈥檛 made pre-tax as they are to the traditional 401(k). But they can be withdrawn along with investment earnings tax-free in retirement, whereas traditional 401(k) distributions are taxed as income.
That鈥檚 of particular benefit if you have a decent stretch of career still ahead of you, and you think your salary is likely to rise during it. If you鈥檙e in a lower income tax bracket now than you expect to be in the future, contributions to the Roth lock in that low rate.
Kevin Wagner, a senior retirement consultant at Willis Towers Watson, says this is why he encouraged his three adult children to choose the Roth from their menus of employee benefits. 鈥淚鈥檇 rather them have that retirement money taxed now at a low current rate, than in my opinion at what might be a higher rate in the future.鈥�
Whether that higher rate is because of an increase in tax rates overall, or to an increase in income throughout your career (which will lead to higher income needs 鈥� and thus taxes 鈥� in retirement in order to maintain that standard of living) doesn鈥檛 matter.
A traditional 401(k) may be more of a gamble
When you contribute to the standard 401(k) pretax, you鈥檙e not eliminating taxes. You鈥檙e kicking them down the road until retirement, when you鈥檒l pay income taxes on the money you withdraw (and you must start required minimum distributions by age 70陆 at the latest 鈥� the IRS wants that tax money, and it isn鈥檛 an organization known for its patience. With a Roth 401(k), you can聽聽and avoid the minimum distribution requirement).
That means a traditional 401(k) defers the tax burden to a later date and time when you don鈥檛 know what your tax situation will be. You may be thinking there鈥檚 a flip side to this situation: Taxes could go down, and if you鈥檝e contributed to the Roth, you鈥檝e prepaid and locked in a higher rate. That鈥檚 true. But you鈥檝e also skated all of your investment earnings right past the tax man at no charge 鈥� not an insignificant amount of money, especially if you started saving early.
The downside to Roth contributions
There鈥檚 a significant difference between the pretax contributions to a traditional 401(k) and the after-tax contributions to the Roth version, which may be one reason why Roth 401(k)s lag in popularity: The after-tax deferral takes a bigger bite out of your paycheck. But depending on your income, the difference may be minimal: On a $40,000 salary, for example, 4% contributions to a traditional 401(k) would save you about $25 a month in taxes.
When you鈥檙e at the peak of your salary climb, you may already be at a high marginal tax rate; electing the Roth option at that point, says Wagner, could mean overpaying versus what you鈥檇 owe in retirement.
It makes sense to diversify
You can鈥檛 tell the future, but you can split the difference 鈥� by making contributions to a Roth 401(k) early in your career, then opting for the traditional version as your salary starts to top out. (Many employers will also let you split contributions if you鈥檇 like, so some goes pre-tax, some post.)
That鈥檒l give you at least two pots of money to pull from in retirement, with different tax treatments. 鈥淭here鈥檚 a value in having the ability to take money from either a taxable or nontaxable account as you age,鈥� says Wagner. 鈥淵ou never know where taxes are going to go, and it鈥檚 at least possible the rules will change. All you can do is make the best educated decision you can.鈥�
Arielle O鈥橲hea is a staff writer at NerdWallet, a personal finance website. Email:聽aoshea@nerdwallet.com.听罢飞颈迟迟别谤:听.
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