The attraction of a Roth 401(k) is simple. You contribute after-tax dollars to the account, which will accrue tax-free earnings and allow for tax-free withdrawals in retirement after age 59½ . Here’s a look at why Roth 401(k)s are catching on, especially among young retirement savers.
More companies offering a Roth option. Roth 401(k) accounts first became available in 2006. But most employers did not immediately introduce this retirement savings option and many existing workers didn’t enroll right away. Employee usage of the Roth option tends to grow rapidly during the first two years it is offered and then stabilize after three years, according to a new Hewitt Associates analysis of 20 401(k) plans with 504,000 participants. While just 7 percent of retirement savers chose the Roth 401(k) account the first year it was offered, 15 percent of 401(k) participants started using it within 3 years of implementation. Approximately 29 percent of employers currently offer a Roth 401(k) and another 25 percent of companies say they are likely to add the feature this year, according to recent Hewitt survey of employers.
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Same 401(k) match. Nearly all the companies in the Hewitt study provided the same 401(k) match for Roth 401(k) contributions as for the traditional 401(k). Loans and early withdrawals were also generally allowed from both types of accounts for the same reasons. However, employer matches to Roth 401(k) contributions must be made into a pre-tax account. Withdrawals from this traditional 401(k) account will be taxed as income in retirement.
Fewer restrictions than a Roth IRA. Retirement savers can only contribute up to $5,000 to a Roth IRA, or $6,000 if they are age 50 or older, in 2010. Investors must also earn below certain income limits to be eligible to contribute to a Roth IRA. Roth 401(k)s have the same higher contribution limits as traditional 401(k)s and no income restrictions. Employees can save up to $16,500 in a traditional 401(k), Roth 401(k), or combination of the two accounts in 2010. Those age 50 and older can contribute up to $22,000.
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Tax diversification. Many retirement savers contribute to pre-tax and after-tax accounts simultaneously. Over half (54 percent) of Roth account holders also save in a traditional 401(k). Roth 401(k) users saved an average of 7 percent of pay in the Roth account and 11 percent of pay overall. Investing in both types of 401(k)s may allow you to hedge your bets against future tax increases.
Tax-free withdrawals in retirement. Your entire traditional 401(k) balance isn’t available for spending in retirement. You must pay income tax on withdrawals each year. With a Roth 401(k), you pay the tax up front and generally won’t have to pay any additional taxes when you take distributions from an account at least 5 years old after age 59 1/2. To decide which type of 401(k) is better for you, compare your current tax rate to what you estimate your tax rate will be in retirement. If your tax rate is higher now than you think it will be in retirement, consider deferring taxes until retirement using a traditional 401(k). But if you expect to be in a higher tax bracket in retirement, you can save by paying the tax now and investing in a Roth 401(k).
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Benefits for young savers. Younger workers are the most likely to use a Roth option. Nearly 17 percent of retirement savers in their 20s have elected to pay taxes on their retirement savings up front, compared to only 4 percent of those in their 50s. New employees with low starting salaries have a lot to gain by choosing the Roth option because they may now be in a lower tax bracket than they will be later in their career and in retirement.