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Do Roth and 401(k) Mix?

The Pension Protection Act of 2006, passed into law late last year, included a number of changes intended to simplify retirement savings. (Wow, that sounds boring, doesn't it? Don't doze off yet, Fool -- this could be important to you.) One of these changes made the Roth 401(k) option, originally set to expire in 2010, permanent. And just last week, the U.S. Treasury Department issued new guidance around the tax treatment and accounting of these plans. Together, these developments removed most of the obstacles cited by employers who had delayed adoption of the Roth option.

According to a survey done earlier this year by the Profit Sharing/401k Council of America, about a quarter of employers with 401(k) plans currently offer a Roth 401(k), and just 8% of employees who are eligible to participate are doing so. I expect the former number to keep growing, especially now that the Treasury has issued guidance, but I wonder about the latter. It has been more than a year since the first Roth plans became available, and people seem to be more confused about the option than ever. What's the scoop?

There's Roth... and there's Roth
Nobody disputes that the Roth IRA has clear benefits for investors in certain situations. Although you can't deduct your contributions, withdrawals from the IRA are tax-free, you can take your contributions out at any time without penalty, and there's no requirement to start taking distributions at age 70 1/2. Like its namesake IRA, contributions to a Roth 401(k) are made after-tax, and the withdrawals are fully tax-free once you're in retirement. But aside from those two distinctions, the rules around the Roth 401(k) mirror those of conventional 401(k) plans, including eligibility, contribution limits, and the need to begin distributions by age 70 1/2. So in truth, the Roth 401(k) is a hybrid of the Roth IRA and a regular 401(k), offering some of the benefits -- and some of the downsides -- of each option.

Pros and cons
Confused yet? Lots of people are. Unlike the Roth IRA, there aren't yet compelling rules of thumb for who should use a Roth 401(k) and when. Some Roth 401(k) proponents argue that taxes are likely to be higher in the future, and suggest that taking the tax hit now makes sense. And even if you're not sold on that argument, they say, if you're just starting out in your career or have some other reason for believing that you'll be in a higher tax bracket at retirement, it makes sense to take the tax hit now. Others are glad to have the flexibility to choose Roth-style options both at and outside of work.

Those arguments have been enough to convince major employers like Microsoft (Nasdaq: MSFT  ) , General Motors (NYSE: GM  ) , and Google (Nasdaq: GOOG  ) to make the infrastructure changes necessary to offer the Roth 401(k) option to their employees, but as noted above, people aren't yet rushing to sign up.

On the flip side, there are those who argue that the Roth plans are a dubious bet. They point out that very few people are actually able to know for sure that they're in a lower bracket now than they'll be in at retirement, and given the uncertainty, opting to contribute to a Roth over a traditional plan means giving up a guaranteed tax benefit now for the not-so-guaranteed chance of a benefit later. Additionally, for some, losing their current deduction can have a larger impact -- if, for instance, foregoing the deduction means your gross income swells to the point where you exceed the limits for other deductions, such as the child care credit.

So what should I do, Fool?
It's problematic stuff, and again, there's no easy answer. If you feel that taxes are likely to go up in the future, and you're in the early stages of your career (or you've exceeded the Roth IRA income limits and want a way to get some Roth-y goodness in your portfolio), opting to contribute to a Roth 401(k) might be a compelling choice.

For others, who may not feel comfortable making a bet on the direction of tax rates, the choice is likely to be murkier. If you are considering switching some or all of your contributions to a Roth 401(k) option, make sure you consider the full effect of such a switch, including the impact on your eligibility for other deductions you regularly claim.

And no matter what you do, make sure you're contributing enough to a 401(k) of whatever type to claim the full amount of your company's match -- leaving that free money behind would definitely not be Foolish.

Related articles:

Whether you choose a traditional or a Roth plan, investing the right way is essential for the success of your overall retirement strategy. For advice on how to put together the best retirement portfolio for you, take a 30-day free trial of the Fool'sRule Your Retirement newsletter service. You'll find simple directions that will set you on your way to a successful retirement.

Fool contributor John Rosevear does not own any of the stocks mentioned in this article. Microsoft is an Inside Value recommendation. The Motley Fool has a disclosure policy.


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John Rosevear
TMFMarlowe

John Rosevear is the senior auto specialist for Fool.com. John has been writing for the Fool since 2007. A lifelong car nerd, his current daily driver is a Cadillac CTS-V.

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