What You Should Know About the Roth 401(k)

Determining when to pay taxes could make all the difference in your retirement nest egg

While many people save for retirement in a 401(k) plan because it lets them defer paying taxes until they withdraw the funds, that approach didn’t appeal to Candi Sparks.

“Everyone assumes they’ll be in a lower income tax bracket when they withdraw the money after retirement, but you might not be,” says the New York-based author of Can I Have Some Money?, a series of financial books for children. “I wanted to save myself from having to pay taxes during my golden years.”

So when Sparks began saving for retirement, she chose not to participate in her company’s 401(k) plan but to save in a Roth IRA instead. With the Roth, she paid taxes on the money upfront, but when she retires, she’ll be able to withdraw her money tax-free.

The only downside in her eyes: The Roth IRA had lower contribution limits than the 401(k) plan so she couldn’t save as much money in the account as she would have been able to with the 401(k). If she could have paid her taxes upfront and enjoyed the higher contribution limits of the 401(k) plan, she would have embraced that option. Today, many employees are enjoying the best of both worlds as more companies are offering a relatively new hybrid between the two called the Roth 401(k).

In 2006, the Roth 401(k) was introduced as a way for Americans to make after-tax contributions to their 401(k) plans. Since the taxes on your contributions are paid up front, the money grows tax-free, so you can make withdrawals once you’re 59 ½ without paying income tax on it. It’s important to note that if your company matches your Roth 401(k) contributions, the taxes are not paid on that portion up front. It’s stored separately from your contributions, and when you withdraw the money that was contributed by your employer, you’ll have to pay taxes on it.

While the Roth 401(k) resembles the Roth IRA as far as the tax situation, the Roth 401(k) is far more generous when it comes to who can make contributions. If you’re single and making $127,000 or more, or married and making $188,000 or more, you can’t contribute to a Roth IRA. If you’re single making between $112,000 and $127,000 or married making between $178,000 and $188,000 jointly, the amount you can save in the Roth IRA decreases as your income rises. However, there are no income restrictions for contributing to a Roth 401(k). You can also put away more in a Roth 401(k).

Not all employers have added the Roth 401 (k) option to their benefits package. In fact, according to a survey released by human resources consulting firm Aon Hewitt, 49% of respondents do not offer the Roth 401(k) to employees. But of those that don’t, 29% said they were very or somewhat likely to add the option in the next 12 months. If your company offers the Roth 401 (k) option or will be offering it in the near future, it may be worth a second look.

If your company offers the option of choosing between a traditional 401(k) plan and a Roth 401 (k) plan, “It comes down to your perspective on when you would like to pay taxes, and your estimated tax bracket,” says Laurie Nordquist, executive vice president and director for Wells Fargo Institutional Retirement and Trust.

You may find the Roth 401(k) option appealing if:

  • You’re young or at the beginning of your career. If you expect to make more money in the future, you may do better paying the taxes now.
  • You’re worried about having enough for retirement or you don’t want to have your nest egg reduced by a tax bill.

On the other hand, you may stick with the traditional 401(k) if:

  • You’re nearing the end of your career, since you’re likely in your prime earning years.
  • You think you’ll make less income after you retire.
  • You want to lower the amount of money that you’re taxed on today

Regardless of whether you choose to save your money in a Roth 401(k), a traditional 401 (k), or a Roth IRA, the most important thing is for you to save, Nordquist says. “The greatest benefit for both the Roth and the traditional 401(k) is the fact that you’re able to let those dollars accumulate.”