Roth IRAs have given the American public a huge tax break in the past decade. They offer a tremendous boost to the power of compounding over time, thanks to their tax-free-forever status. In addition, they offer some other great features, including no requirement to start taking distributions at age 70 1/2, the ability to pass the account on to your heirs tax-free, and the ability to take your original contributions out at any time without penalty.
But the offshoot from Roth IRAs -- the Roth 401(k) plan -- is a less obviously compelling savings option. As with a Roth IRA, contributions to a Roth 401(k) are made after-tax, and the withdrawals are fully tax-free once you're retired. But beyond that, it's more like a regular 401(k) than its fellow Roth option, with the same limits -- and the same need to start taking distributions at age 70 1/2.
The lack of a stampede of new money into these products reflects their somewhat muddy status. While about 37% of 401(k) plan sponsors have either added a Roth option or have one in the works, according to a June survey by the Employee Benefit Research Institute and benefits-consulting firm Mercer, only about 8% of eligible participants have signed up. Major employers have led the way for the most part, with prominent names such as Microsoft
So what's a Fool to do? As I see it, there are currently two strong arguments for considering a Roth 401(k):
As a back-door way to fund a Roth IRA. When you leave your job and go to roll over your Roth 401(k), you can roll it into a Roth IRA -- even if you're over the Roth IRA income limits. This is one good way to get a lot of money into a Roth IRA, with all of its clear-cut advantages. Of course, you've got to leave your job to do it, and doing so may not be part of your plans.
- As a tax diversification strategy. If your tax rate is higher at retirement than it is now, whether because you've accumulated vast wealth or because Congress has raised rates in the interim, tax-free Roth income (funded by contributions taxed at your lower current rate) will have a big advantage over taxable income from traditional accounts. Of course, it's hard to predict where tax rates will be 20, 30, or 40 years from now, which makes the idea of hedging your bets through diversification attractive. Just as you diversify your investment portfolio by holding different classes of assets or stocks in different industries, you can address the uncertainty around future taxes by putting some of your investments in traditional accounts and some in Roth accounts.
Of course, Roth 401(k)s still have some downsides, some of which can be major, depending on your situation:
Tax implications. Switching your 401(k) contributions from a traditional plan to a Roth option will raise your taxable income. Depending on your individual situation, this might threaten your eligibility for certain deductions and, worse, expose you to the dreaded Alternative Minimum Tax. If your accountant or tax preparer has been telling you that you "just missed the AMT" in recent years, look carefully before leaping to a Roth.
More tax implications. Another way to look at the traditional-versus-Roth distinction is that, by switching from a traditional 401(k) to a Roth, you're giving up the certainty of a tax benefit now for the chance of maybe a bigger benefit later. How do you feel about that?
- Your employer match won't get Rothed. Even if you opt for a Roth 401(k), your employer's matching contributions -- which are still pre-tax -- will go into a traditional account. This may be no big deal to you -- indeed, if tax diversification is your goal, it may help you out -- but some have found the idea of managing and planning around two separate accounts to be a significant hassle.
So what's the upshot? Well, how do you feel about the future direction of taxes? And what would adding several thousand dollars of taxable income do to your tax situation? Unfortunately, there's no clear-cut recommendation or rule of thumb here. If you are tempted to switch, make sure you explore all of the tax implications -- schedule some time with an accountant to review them if necessary. And, of course, whatever you do, make sure you're contributing enough to collect the full amount of your employer's match.
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's Rule Your Retirement newsletter service. There's absolutely no obligation to purchase.