Millions of workers take advantage of 401(k) plans to save for retirement. Yet before you start contributing to a 401(k), you might be fortunate enough to have another decision to make: whether to direct your contributions toward the regular side of your 401(k) plan, or into a Roth 401(k).
Below, you'll find some direction on how to make the smart choice for your financial situation; but first, let's take a look at the history of the Roth 401(k), and how it came to be an option for retirement savers.
The Roth 401(k): A new animal
Retirement savers have had the opportunity to save outside of work in Roth IRAs for nearly 20 years. The creation of the Roth IRA in 1997 revolutionized retirement planning, as it allowed investors to take after-tax money and put it in a dedicated retirement account. In exchange for giving up the upfront tax break on their contributions, Roth IRA investors got the benefit of tax-free treatment for the income their investments generated because, unlike regular IRAs, qualifying withdrawals from Roth IRAs aren't included in income.
Yet for nearly 10 years after lawmakers created the Roth IRA, participants in 401(k) plans didn't have the same flexibility that IRA investors had. It was less than a decade ago in 2006 that new legislation created the Roth 401(k) plan. These plans allowed worker-participants to choose whether to have contributions treated as pre-tax, after-tax, or a combination of the two, with the respective tax benefits of traditional and Roth accounts applying to each part of a worker's 401(k) plan account separately.
Employers aren't required to offer the Roth 401(k) option, although many changed their plans after the new provision became law in order to offer it on a going-forward basis. If your employer has adopted the appropriate provisions into its 401(k) plan, then you'll have a decision to make: Should you take advantage of the Roth 401(k) provision by saving after-tax money, or stick with the tried-and-true traditional pre-tax 401(k) contribution?
When is the Roth 401(k) better?
The decision on whether to use the traditional or Roth side of a 401(k) is more complex than you'd think. The problem is that you're essentially trying to decide whether it makes sense to pay tax now or in the future.
The reason this holds is that if you make Roth contributions, they're with after-tax money that you've paid tax on currently; but you won't have to pay tax when you withdraw the money in retirement. If you stick with regular 401(k) contributions, then they're with pre-tax money for which you'll get a current tax break -- but you'll have to pay taxes later when you withdraw that money in retirement.
Ordinarily, deferring tax as long as possible is a smart move, but the key determination you have to make is whether you think the taxes you'll pay now are less or more than what you'll pay in the future. Obviously, that's impossible to predict perfectly, but there are generally a few situations in which you should strongly consider the Roth option.
First, young adults who have relatively low levels of income can often benefit the most from a Roth 401(k). Because salaries tend to rise over time, you're usually in the lowest tax bracket in your lifetime early in your career, so foregoing a tax break that does you relatively little good is worth it to save far more in taxes later in life.
Second, if you already have a large amount of assets in taxable accounts and traditional 401(k) or IRA accounts, then putting money into a Roth 401(k) can be a smart move. With plentiful assets for your retirement years, you'll probably still be in a high tax bracket even after you retire, and with recent trends that have pushed up tax rates for the wealthiest taxpayers, effectively locking in current rates by directing contributions to a Roth 401(k) might be a prudent move.
Finally, it can make sense to put a portion of your 401(k) contributions into a Roth account just to diversify your tax exposure. A 50-50 split, for instance, will give you some upfront benefits from the traditional contributions, and some long-term Roth benefits. That could be the easiest way to solve what could otherwise be a tough decision.
Having to decide on a Roth 401(k) might seem like just another hassle, but the Roth option can actually be very helpful. Take a look at your situation, and you might find that using a Roth 401(k) can give you a nice boost to your retirement savings.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.