Heads up, new-grads-turned-new-employees: Somewhere in the middle of a lengthy orientation presentation and an even lengthier employee handbook, you might find a benefit that’s easy to overlook: the Roth 401(k), sister to the standard 401(k).
Over half of employers offer both options these days, according to new research from global advisory firm Willis Towers Watson, yet less than 10% of employees on the receiving end are taking advantage of the Roth. That number should be higher.
The benefits of the Roth 401(k)
For some workers, particularly young ones, the Roth 401(k) isn't just the sister to the 401(k), it’s Cinderella: It imposes Roth IRA tax treatment on the standard version, which means contributions aren’t made pre-tax as they are to the traditional 401(k). But they can be withdrawn along with investment earnings tax-free in retirement, whereas traditional 401(k) distributions are taxed as income.
Why is that of particular benefit to the youngest employee set? Because they’re likely to be earning the lowest salaries now, which means they’re also paying low marginal tax rates, says Kevin Wagner, a senior retirement consultant at Willis Towers Watson. Contributions to the Roth lock in that rate.
Wagner says he encouraged his three adult children to choose the Roth from their menus of employee benefits. “I’d rather them have that retirement money taxed now at a low current rate, than in my opinion at what might be a higher rate in the future.”
Whether that higher rate is because of an increase in tax rates overall, or to an increase in income throughout your career (which will lead to higher income needs — and thus taxes — in retirement in order to maintain that standard of living) doesn’t matter.
A traditional 401(k) may be more of a gamble
When you contribute to the standard 401(k) pretax, you’re not eliminating taxes. You’re kicking them down the road until retirement, when you’ll pay income taxes on the money you withdraw (and you must start required minimum distributions by age 70½ at the latest — the IRS wants that tax money, and it isn’t an organization known for its patience. With a Roth 401(k), you can roll the account over to a Roth IRA and avoid the minimum distribution requirement).
That means a traditional 401(k) defers the tax burden to a later date and time when you don’t know what your tax situation will be. You may be thinking there’s a flip side to this situation: Taxes could go down, and if you’ve contributed to the Roth, you’ve prepaid and locked in a higher rate. That’s true. But you’ve also skated all of your investment earnings right past the tax man at no charge — not an insignificant amount of money, especially if you start saving early.
The downside to Roth contributions
There’s a significant difference between the pretax contributions to a traditional 401(k) and the after-tax contributions to the Roth version, which may be one reason why Roth 401(k)s lag in popularity: The after-tax deferral takes a bigger bite out of your paycheck. But when you’re just starting out, the difference may be minimal. On a $40,000 salary, for example, 4% contributions to a traditional 401(k) would save you about $25 a month in taxes.
It’s also reasonable to assume your tax rate will be higher in retirement than when you’re at the start of your career. When you’re at the peak of your salary climb, you may already be at a high marginal tax rate; electing the Roth option at that point, says Wagner, could mean overpaying versus what you’d owe in retirement.
It makes sense to diversify
You can’t tell the future, but you can split the difference — by making contributions to a Roth 401(k) early in your career, then opting for the traditional version as your salary starts to top out. (Many employers will also let you split contributions if you’d like, so some goes pre-tax, some post.)
That’ll give you at least two pots of money to pull from in retirement, with different tax treatments. “There’s a value in having the ability to take money from either a taxable or nontaxable account as you age,” says Wagner. “You never know where taxes are going to go, and it’s at least possible the rules will change. All you can do is make the best educated decision you can.”
MORE:How much should you save for retirement?
Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.
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