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The 401(k) Strategy You Should Use Now

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When the Roth IRA first became available in the late 1990s, it changed the way people saved for retirement. Yet when similar features appeared within employer-sponsored retirement plans -- like 401(k)s -- in 2006, the response was far less enthusiastic.

After a few years, however, the Roth 401(k) has finally started to gain some traction. Merrill Lynch (NYSE: MER  ) reported a 21% jump in Roth 401(k) plans among its clients in the first quarter. T. Rowe Price (Nasdaq: TROW  ) has seen usage of Roth 401(k)s rise 50% since last year. And numbers from several other retirement plan providers, including Vanguard, Hartford Financial (NYSE: HIG  ) , and Fidelity, show significant growth both in the number of employers offering Roth 401(k)s and the number of employees using them.

So if you have access to a Roth 401(k), should you be using it? And if it's not available, should you push your employer to adopt a Roth 401(k) option in your retirement plan?

Advantages of the Roth 401(k)
Just as Roth IRAs have different characteristics from traditional IRAs, Roth 401(k)s offer some advantages over their regular 401(k) counterparts. With all Roth options, there's a trade-off involved. As long as you follow the rules, you'll never have to pay income tax on any distributions from your Roths. But to get this benefit, you have to give up one of the best features of traditional 401(k)s: the up-front tax deduction on every dollar you contribute.

It's that trade-off that may have made employers hesitate to add Roth 401(k) options to their retirement plans. With many employers already struggling to get employees to participate in their plans, some were concerned that making a Roth option available would only complicate things further, confusing employees and discouraging participation.

Some major employers, including Microsoft (Nasdaq: MSFT  ) , Google (Nasdaq: GOOG  ) , and General Motors (NYSE: GM  ) , were quick to add Roth 401(k)s to their retirement plans. Yet despite payroll firms like Paychex (Nasdaq: PAYX  ) adding Roth capability for their clients back in 2006, the added burdens of plan administration led many employers to adopt a wait-and-see approach.

Looking for certainty in an uncertain world
Now, though, as the coming election brings the possibility of big changes to the income tax system, Roth 401(k)s are getting more attention. With the uncertainty over future tax rates, the benefit of diversifying your tax exposure has gained in importance.

The concept behind tax diversification is that when you have a large amount of your retirement assets in traditional IRAs and 401(k) accounts, you're vulnerable if income tax rates rise by the time you withdraw your money. For instance, if the current 25% tax bracket were to rise to 40% by the time you retire, the gains from decades of tax deferral would be largely offset by the added tax burden when you take money out of your retirement accounts.

Roth accounts -- both IRAs and 401(k)s -- let you essentially lock in your tax rate upfront when you fund your account. Using the previous example, by forgoing a current tax deduction worth 25%, you avoid having to pay the higher 40% tax rate later.

Who benefits most
Two sets of people get the biggest benefit from Roth 401(k)s. On one hand, there are income limits for Roth IRA contributions -- for single filers earning more than $116,000 or joint filers with income over $169,000, you're not allowed to contribute to a Roth IRA at all. The Roth 401(k), however, has no income limit. So for high-income taxpayers, the Roth 401(k) is their only access to a Roth-style account.

At the other end of the spectrum are those in the lowest tax brackets, such as those just starting out in their careers. For them, current tax deductions aren't worth very much, but if they succeed in saving a substantial nest egg, they may easily find themselves in higher tax brackets during their retirement.

For everyone else, having a Roth 401(k) may not be essential. But as a hedge against higher taxes, having a combination of traditional and Roth-style retirement accounts may be your best bet.

For more on your retirement savings options, read about:

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Fool contributor Dan Caplinger doesn't have access to a Roth 401(k), but he dutifully funds his Roth IRA every year. He doesn't own shares of the funds and stocks mentioned in this article. Paychex is a Motley Fool Income Investor selection. Microsoft is a Motley Fool Inside Value pick. Google is a Motley Fool Rule Breakers recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy pays dividends.

Read/Post Comments (3) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 28, 2008, at 5:03 PM, Ken6626 wrote:

    Everyone who says Roth IRAs are better always asserts that your retirement tax rate may be higher than your current rate.

    Well two other things can happen when you retire: 1 - the rate may not be higher; 2 - the tax law can change to make the Roth distributions taxable.

  • Report this Comment On August 28, 2008, at 9:00 PM, warmeyes wrote:

    2- Since you will have already paid taxes on your contributions, it's hard to believe taxing them again later will be politically feasible. Yes, anything's possible, just unlikely.

    1- Even if the rate isn't higher, all of your GAINS will not be taxable either. Good for monies that will earn steady interest, for example.

    And there's no enforced withdrawal, and any part that you leave to your heirs will not be taxable.

    If you can convert a standard IRA to a Roth during a year when you won't otherwise pay taxes, or are unemployed, say, it's really worth considering.

  • Report this Comment On August 29, 2008, at 4:28 AM, FOOLBEFREE wrote:

    For high income people who have to do non-deductible IRAs, contribute to these and then convert to Roth IRA in 2010 and 2011. You will pay the tax on the gains, not the contribution because it was already taxed.

    ---> All future withdrawals from the converted Roth IRA will be tax free. I made some calculations and this produces significant tax savings. I will be converting in 2010/11 and have been contributing to a traditional IRA every year.

    --> Converting on a year of low income is also a great strategy mentioned on the previous comment by warmeyes. Great advice.

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