According to a report released earlier this year by AON Hewitt, 50% of employers now offer a Roth 401(k) option to employees. However, among companies who offer Roth retirement plan options, just 11% of participants take advantage of the option.
Source: 401kcalculator.org via Flickr.
So what is a Roth retirement plan, and how is it different from the traditional 401(k) options? And should you consider contributing to a Roth plan as part of your own retirement strategy?
More employers are offering Roth options in their plans
Over the past several years, employers have been increasing the availability of Roth features in their defined-contribution retirement plans. In fact, since 2007 the percentage of employers offering Roth accounts has grown from just 11% to 50% today.
However, the plans have been somewhat slow to catch on with employees. Even among companies that have offered Roth features the longest (seven years or more), just over 18% of participants take advantage.
Roth accounts are the choice of young, serious savers
The Roth options tend to be most popular among younger workers and those in the $60,000-$99,000 salary range.
In fact, as a percentage of workers who have access to Roth retirement options at work, nearly twice as many workers aged 20-29 decide to participate as do workers aged 50-59.
Further, the average Roth user chooses to contribute more to their retirement plans (10.2% of their income) than those who choose not to use the Roth option (7.7% of income). And this effect is further amplified by the tax benefits that come with Roth accounts. Simply put, a dollar saved in a Roth account is worth more over the long run than a dollar saved in a traditional (pre-tax) account.
The difference is all about taxes
The main difference between Roth retirement options and traditional selections is the tax treatment.
In a traditional 401(k) or similar account, your contributions are deducted from your paycheck on a pre-tax basis. In other words, you don't pay taxes on that portion of your income during the current tax year. For example, if you earn $100,000 per year and contribute 5% of your salary to a pre-tax account, you don't pay current taxes on $5,000 of your salary.
However, when you eventually withdraw the money, you'll have to pay income tax at whatever tax bracket you fall in at that time.
Meanwhile, contributions to a Roth retirement account are made on an after-tax basis. In other words, the amount you decide to contribute is not deducted from your current year's taxable income. So, if you earn $100,000 and contribute $5,000 to a Roth retirement option, it doesn't reduce your taxable income for this year.
What it does is allow you to pay taxes on the money now, rather than later. When you retire, your account will (hopefully) contain not only your original contributions, but a whole lot of gains as well. So you'll be able to withdraw the money from your account without having to pay any taxes whatsoever.
Pay more now, get more later
Let's say you're in the 25% tax bracket right now. In this case, if you contribute $5,000 to a Roth retirement account, you'll still have to pay tax on that money this year, so the contribution effectively costs you $6,250.
However, by making this sacrifice now, you'll most likely end up with a lot more income down the road.
But isn't the end result the same whether you pay taxes now or later? Well, sure, if you're still in the same tax bracket after you retire. If tax rates go up in general over the next 30-40 years, or if you're simply in a higher income bracket when you retire, you'll be very glad not to have to pay taxes on your withdrawals.
While there are definitely valid arguments in favor of both retirement options, one of the reasons a Roth 401(k) is great in your defined-contribution plan is that if you contribute a certain percentage of your salary, the net effect is a higher contribution to your retirement, given that you're "prepaying" your tax liability to the IRS in addition to the set contribution. It'll mean a little less of a tax refund this year, but you probably won't even notice it. Besides, that little tax sting now could mean thousands more over the long run.
Should you change your strategy?
That depends on how you feel about giving up a pretty decent tax benefit now in favor of additional income when you retire. Personally, I think Roth accounts are an excellent choice, especially for young investors.
Not only does a Roth effectively increase your retirement contributions, but it takes the uncertainty out of your tax situation. If your money is tied up in pre-tax accounts and tax rates rise significantly between now and when you retire, you could find yourself paying tens or even hundreds of thousands of dollars more to the IRS than you planned on.
With a Roth account, you really don't have to worry about taxes. Maybe your income tax rate will skyrocket 50% by the time you retire (hey, it could happen). If your money is in a Roth account, who cares?
Another option is to use both types of accounts. The report I mentioned earlier found that the average Roth user's 10.2% retirement savings rate was split between the two account types, with an average of 3.8% of the employee's salary going into a traditional pre-tax account.
So ask yourself when you would rather pay taxes and whether you can afford to take a small tax hit now in order to get some nice gains later on. If so, a Roth account may be the way to go.
