In the last blog post, we covered the ABC's of the Roth 401(k) plans that many employers have introduced in recent years. But are these plans right for you, or should you stick to contributing to the traditional 401(k)? Let's talk about some of the circumstances that would make Roth 401(k) contributions more attractive.
If most of your retirement nest egg is in accounts funded with pre-tax contributions, Roth 401(k)'s offer you the opportunity for "tax diversification". Traditonal 401(k)'s, 403(b)'s and tax-deductible IRAs are especially beneficial if your marginal tax rate is higher now than it will be when you withdraw from these accounts. Of course, it's often very difficult to tell in advance if this will be the case. So Roth accounts offer you the chance to hedge your exposure to future tax rates since they are even more valuable if tax rates rise.
Along these same lines, if you believe that the government must eventually raise income tax rates to fund our deficits, and to shore up Medicare and Social Security, then Roth 401(k)'s might be the ticket for you. Assuming that Roth withdrawals would remain tax-free in this scenario, these accounts would be powerful and dependable sources of retirement funds.
With respect to advance planning for retirement expenses, Roth 401(k)'s take one of the many variables out of the equation. Retirement projections will be more accurate and meaningful since we don't have to make assumptions about future tax rates in retirement when account withdrawals eventually are made.
For those of you who are more concerned about passing on wealth to future generations than funding retirement, Roth 401(k)'s offer a potential means to accomplish this objective that might otherwise be unavailable. Roth accounts are not subject to required minimum distributions (RMD's), so they can remain intact for beneficiaries, who will receive distributions tax-free. Unfortunately for now, there are income limits preventing many of you from contributing to Roth IRAs. In this regard, contributing to Roth 401(k)'s and then eventually rolling them over into Roth IRAs might be the only chance for some to avoid RMD's and pass on retirement account wealth intact.
And finally, for the avid savers among you, Roth 401(k)'s effectively allow you to contribute more on an "after-tax equivalent" basis than the traditional 401(k). In essence, when you contribute to the latter, the government still has a future claim on that asset amounting to its share of the eventual withdrawal. So while the IRS contribution limits are the same for the 2 types of 401(k)'s, you are essentially socking away more for the future in a Roth.