A 401(k) is already one of the best ways to save for retirement, but many plan sponsors now offer one step better: a Roth 401(k).
If you could build the ideal retirement account, this might very well be it. Like a 401(k), there’s a high, $18,000 annual contribution limit, or $24,000 for those 50 or older. As with a Roth IRA, you make contributions with after-tax dollars, but qualified distributions are tax-free. If you earn so much that your Roth IRA contribution limit phases out, a Roth 401(k) gives you access to that coveted tax-free growth.
With that list of high points, you might be wondering where to sign. And with rare exceptions, most workers who are offered this retirement account should take it. But here’s what to consider before you do.
This is the dividing line between a Roth and traditional tax treatment: If you expect your tax rate to be higher when you pull the money out in retirement, you’re better off paying taxes now and avoiding them later with a Roth 401(k).
Many people fall into this box, either because of a standard of living that increases over time and requires them to draw more income in retirement, or because they expect across-the-board tax increases between now and then. With a Roth, you get to lock in that current low tax rate, then enjoy tax-free growth on your investments.
Even if you expect your tax rate to go down in retirement, a dollar in a Roth 401(k) is worth more than a dollar in a traditional 401(k), says Tim Maurer, a certified financial planner and author of “Simple Money: A No-Nonsense Guide to Personal Finance.”
“Virtually all the time, for people who are considering making a contribution, the Roth dollar is more valuable, because the traditional is going to require tax payment,” he says. When you pull a dollar out of a Roth, you put that dollar in your pocket. When you pull a dollar out of a traditional 401(k), you put that dollar minus taxes in your pocket. That could leave you with 75 cents — maybe a little less, maybe a little more.
The only way a traditional meets the value of a Roth is if you expect your future tax rate to be lower — and you immediately invest the value of the tax deduction you receive now from contributing to a traditional 401(k). If you put $4,000 into a traditional account this year and you do the math to determine that the tax deduction on that contribution is worth $1,000, you need to invest that $1,000 as well.
You can do that out of cash flow or from your tax refund. But many people don’t get a tax refund, and about half of those who did expect one last year planned to spend it, according to a National Retail Federation survey. That means the second part of this decision comes down to behavioral finance: Can you trust yourself to invest, rather than pocket, those tax savings each year? If not, go Roth.It doesn’t have to be all or nothing
Despite the growing availability of these plans, less than 10% of employees who are offered a Roth choose that version of a 401(k), according to a survey this year from global advisory firm Willis Towers Watson. One possible reason: Because you lose the initial tax deduction, it costs more on the front end to make that choice.
“I typically suggest that a person who is considering introducing the Roth 401(k) do so slowly and over time. Year one, you can split the contribution so 75% goes to the traditional and 25% goes to the Roth. You won’t feel the tax bite as much,” Maurer says.
If you do that, you’ll also head into retirement with tax-deferred and tax-free pots of money, which can help you manipulate your taxable income each year. For instance, the ability to pull some of the money you need in a given year from a Roth can lower your taxable income, which could help you reduce or eliminate taxes on Social Security benefits and lower Medicare premiums that are tied to income.
“Even if you’re someone for whom the tax benefit seems to be negligible, merely having a bucket of money that is tax-free can be a huge advantage in retirement,” Maurer says.
This article was written by NerdWallet and was originally published by The Associated Press.