What's better than a big pile of presents under the tree? How about a retirement account piled high with tax-free cash?
Put the new Roth 401(k) on your list of nice financial friends who deserve a really big present this year, and next year, and the year after that, and the year after that ...
Remember the old advertisements for Reese's peanut butter cups? You got chocolate in my peanut butter! You got peanut butter on my chocolate! Well the Roth 401(k) combines two great retirement vehicles into one very nice package. It melds the save-at-work advantages of a 401(k) account with the pay-taxes-now-and-avoid-them-later advantages of a Roth IRA. (You can find out more about both in the IRA Center and 401(k) Center.)
Look for the Roth 401(k) to grow in availability beginning next year. You can thank a recent pension law, which removed the end-of-decade expiration on the Roth 401(k)s' authorization, for that. If your employer offers one, keep reading. If your employer doesn't, it may be worth having a chat with your friendly human resources representative.
Like a regular 401(k), employers must make Roth 401(k) accounts available to their employees for workers to contribute. Money comes out of your paycheck, but with a new wrinkle. In a traditional 401(k), you contribute before paying taxes. With the Roth 401(k), you pay taxes before stashing away your money.
The result is that your taxable income does not go down, as it does with regular 401(k) contributions. However, once you've paid taxes on that money, you'll never have to pony up for the tax collectors again (as long as you follow the rules, of course). Your money grows and can be withdrawn free of taxes after age 59-and-a-half.
Isn't that nice? Don't these lovely little accounts deserve a little something in their stockings this year?
Who could benefit most from this little present from Uncle Sam? An analysis by the Vanguard Group has some suggestions. Do you save the maximum in your 401(k) each year? You can effectively stuff more in there by contributing to a Roth 401(k). That's because you'll never drain the resources you store in the account for taxes. It's all yours.
Do you expect to be in a higher tax bracket in retirement? This group, in particular, includes young workers whose salaries might be relatively low right now. By using a Roth 401(k) and paying taxes immediately, you lock in a tax rate lower than what you might pay in the future when you start taking distributions from your account. That can be a significant tax savings.
Do you no earthly idea what your tax rate will be in retirement? If you're decades from imagining you'll ever withdraw your retirement funds, you might opt for a Roth 401(k) to give yourself a measure of tax diversification. After all, who really knows what the future will bring? Like spreading your investments among stocks and bonds, using retirement accounts with different tax treatments can hedge against increases in tax rates that may be on the distant horizon.
So lay out some cookies and a glass of milk for Santa Claus, but spend your extra holiday dollars on contributions to a Roth 401(k). It could return the gifts for years to come.
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Fool contributor Mary Dalrymple welcomes your feedback.
