It's bad news for many workers that pensions are becoming harder and harder to find, making it most workers' responsibility to sock away money for retirement. A bit of good news, though, is that there now exists the Roth 401(k), which is an extra-powerful tool for beefing up nest eggs.
Here are some things you should know about Roth 401(k)s:
You may not have heard of them, but Roth 401(k)s are not exactly new, as they were launched in 2006. They're sometimes called designated Roth plans.
How Roth 401(k) works
The Roth 401(k) is a bit of a cross between a regular 401(k) and a Roth IRA. A 401(k), as you probably know, is an employer-sponsored plan that lets you sock away money on a pre-tax basis (thus reducing your current taxable income) in order for it to grow and ultimately be taxed upon withdrawal in retirement. A traditional IRA is quite similar, but doesn't require an employer. You open a traditional IRA account and contribute dollars that reduce your taxable income, and your withdrawals are taxed in retirement. The Roth IRA is different, though, being funded with post-tax dollars. Its benefit is a big one: If you play by the rules, you get to withdraw money from it tax-free in retirement. So ... as you might have guessed by now, the Roth 401(k) is an employer-sponsored plan where you contribute a portion of your income (without your taxable income getting reduced) – and ultimately withdraw money from the account tax-free.
Advantages over Roth IRAs
The Roth 401(k) has a bunch of advantages over Roth IRAs. For one thing, there's no restriction on participation tied to your income, allowing even high earners to use Roth 401(k)s. The total annual amount you can contribute to one or more 401(k) accounts is $17,500 in 2014 (plus $5,500 for those 50 and older), significantly surpassing the total IRA limit of $5,500 (plus $1,000 for those 50 and older). Then there are matching contributions from employers. As with regular 401(k)s, your company can kick in extra, free dollars to your Roth 401(k) account on a matching basis.
One disadvantage compared to the Roth IRA
As with traditional IRAs, Roth 401(k) distributions are mandatory, beginning by age 70 1/2, unless you're still working or are a "5% owner" in your employer. Roth IRAs don't require withdrawals at any time during your life. (With the current rules, you may be able to avoid minimum required distributions by rolling your Roth 401(k) into a Roth IRA at some point.)
Advantages over regular 401(k)s
The Roth 401(k) is very much like the regular 401(k), but its key difference is a very significant one – qualified withdrawals in retirement are tax-free. This is a particularly sweet advantage if you accumulate a lot of earnings in your account over time. When you start pulling that money out in retirement, you'll save a lot by not paying taxes on it.
The conversion option
Regular 401(k) accounts can be converted into Roth 401(k) accounts, but doing so involves paying taxes on the untaxed contributions and earnings in the old account. It can still be well worth undertaking, but be sure to crunch numbers and perhaps even consult with a tax pro before making this move. Recently, 27% of 401(k) plans that offered the Roth option also offered in-plan conversions, with more planning to add them.
Roth 401(k)s are underutilized, but growing in popularity. According to a 2013 study by the folks at Aon plc, about half of employers now allow employees to make Roth contributions, up from just 11% in 2007. Still, most workers with access to a Roth 401(k) aren't using it, but the numbers are rising, with 18% using one at workplaces that have offered it for at least seven years.
Workers with 403(b) or 457(b) plans should know that Roth forms of those plans also exist. If your employer doesn't offer a Roth option, ask that it be considered.
Who benefits most – and least
It's hard to say exactly who should or shouldn't opt for the Roth 401(k), but it's likely to be beneficial for many folks. If you expect to be in a higher tax bracket in retirement, then the Roth 401(k) is especially appealing, as you'll avoid that tax hit. If, as in the typical scenario, you expect to be in a lower tax bracket, it can seem advantageous to stick with a regular 401(k) and defer your taxation until later. But think of your earnings. If your account grows to a hefty size due to investments that did well, you'll be able to withdraw all that tax-free. Consider age, too, as younger folks have longer for their money to grow before retirement, and more to gain from Roth accounts.
There's more to learn and know about IRAs and retirement planning. Take some time to get savvier, and you can end up making your retirement more comfortable.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.