"How do I evaluate whether it makes more sense to go with a traditional 401(k) or a Roth 401(k)? I'm in the 28 percent tax bracket and save 20 percent of my income for retirement. At 25, I'd only be able to make a crapshoot guess [about the tax bracket I'll be in come retirement]." --Bob, Washington, D.C.
Deciding whether a 401(k) or Roth 401(k) is best for you really comes down to your age and future earnings potential.
In a traditional 401(k), you contribute income pre-tax, and then pay taxes on the funds when you withdraw them during retirement. Switch to a Roth, though, and you pay the taxes upfront so you can make withdrawals tax-free during retirement.
At 25, your age makes you an ideal contributor to a Roth account, since your contributions will have decades to grow tax-free, said Stuart Ritter, a financial planner and vice president at T. Rowe Price Investment Services. "The Roth gives you the tax break on the earnings, no matter how big that earnings stack is," he said.
You're also likely to earn a higher income as your career progresses, which means the taxes you pay now will likely be lower than those you would pay in retirement. Switching to a Roth will inevitably mean that your current tax bill will go up, but it will also give you more spendable income in retirement.
If the tax hit you'll take now is too much, you could split your annual contributions between a traditional 401(k) and a Roth 401(k).
But remember, federal law caps contributions at $17,500 (or $23,000 for those 50 or older), regardless of which kind of 401(k) you choose.
Younger workers (whose employers offer a Roth option and conversion) will also be able to convert their traditional 401(k) balance to a Roth 401(k) account, under a provision of the fiscal cliff deal, although the procedures are still being hammered out by the IRS and service providers.
Previous rules only allowed Roth 401(k) conversions for certain savers age 59 1/2 and older. The conversions are best for people in lower tax brackets who have extra cash on hand and can afford to pay the added tax bill.