Adding Roth options to your saving plan
My employer will offer a Roth 401(k) this year. Should I start adding to this new plan?
By Walter Updegrave, MONEY Magazine senior editor


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NEW YORK (CNNMoney.com) - My employer will offer the option of contributing to a Roth 401(k) this year. I've contributed the maximum to my regular 401(k) plan in prior years and I've also made contributions to a Roth IRA. Should I switch my contributions to the Roth 401(k) or stick with a regular 401(k) account?

-- Angelo Gonzales, Morristown, NJ

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How lucky you are to have such an accommodating employer! Although the Economic Growth and Tax Relief Reconciliation Act of 2001 allows companies to establish Roth 401(k)s starting this year, fewer than 20 percent of firms plan to do so at this point, according to a recent survey by the Profit Sharing/401(k) Council of America. Perhaps more employers will jump onto the slowly moving Roth 401(k) bandwagon in the future. So for now at least, most workers won't have the Roth 401(k) option.

But for people like you who do have a choice, the question is whether you should take advantage of it. The answer depends on a number of factors, including how good a saver you are, what tax bracket you're in now and what bracket you'll be in at retirement and how much flexibility you'd like to have when drawing money from your retirement accounts after you call it a career.

Mirror images

A regular 401(k) and a Roth 401(k) are essentially mirror images of each other. With a regular 401(k), you get your tax break up front because you contribute pre-tax dollars, or money that's yet to be taxed. Your contributions, as well as all earnings on those contributions, aren't taxed until you pull the money out.

With a Roth 401(k), on the other hand, you contribute money that has been taxed, but you pay no tax when you withdraw your contributions and the earnings on those contributions. So you get your tax break at the end.

So why should you opt for one other than the other? Well, if you think your tax rate will drop after you reach retirement, then the regular 401(k) is a better deal, since you'll have avoided taxes when your rate was higher and paid them at withdrawal at a lower rate. If, on the other hand, you think your tax rate will increase in retirement, then you're better off with the Roth 401(k), since you'll have paid your tax earlier on when rates were lower and you'll escape paying tax at the higher rate.

That means that there are some scenarios where you may be more likely to benefit from the Roth.

When does the Roth make more sense?

Let's say you're just starting out in your career and are in a low tax bracket because your earnings are low or because you qualify for a lot of tax deductions. In that case, the immediate tax savings you get from a regular 401(k) may be rather small. But if your career prospects are bright, chances are your salary will increase substantially in the future, moving you into ever-higher tax brackets.

So instead of taking the smaller tax cut you'd get by contributing to a regular 401(k), you may be better off paying the tax, contributing to the Roth and sidestepping taxes when you're in a higher bracket.

Similarly, if you're a big saver who will accumulate very large balances in retirement in traditional 401(k)s and IRAs, then you probably will also want to consider a Roth.

Why? Well, withdrawals from regular 401(k)s and IRAs will be taxed at ordinary income rates. And the larger those withdrawals, the more likely you'll be pushed into a higher tax bracket. Having money in a Roth 401(k) will give you a source of funds that won't be taxed (and also won't help push you into a higher bracket).

A Roth 401(k) can also be a good if you plan to work in retirement. The reason is that taxable job income combined with taxable withdrawals from regular 401(k) and IRAs, could easily push you into a higher tax bracket than you'd otherwise be in. That's not a problem with the Roth, however, since Roth withdrawals aren't taxed.

Of course, we can't know for sure what tax rate we'll face in retirement. But even if you're not sure that you'll face a higher tax rate later in life, I still think there's a good reason to consider a Roth 401(k) if you've got the option: it may help you boost your after-tax income in retirement.

After you retire, you'll likely have years when you have large unexpected expenses -- a big medical bill, a home repair, whatever. Pulling extra money from your regular 401(k) or IRA to cover such expenses could push you into a higher tax bracket. As a practical matter, that means you would have to increase the size of the withdrawal to compensate for the higher tax bill.

If you have a Roth 401(k), however, you can cover the expense with a tax-free withdrawal from that account. Result: both your tax bill and the size of your withdrawal are lower than would be the case with a regular 401(k) or IRA.

In short, having money in a Roth account gives you a lot more flexibility for managing your withdrawals, and your tax bill, during retirement. For more on the benefits of having different pots of retirement money taxed at different rates -- or what I like to call "tax diversification" -- click here.

Use it if you can

To sum up, if you fall into any of the scenarios outlined above that make a Roth 401(k) a good bet, then I think you ought to take advantage of that option.

And even if you're not sure whether you'll fall into any of those categories, it's probably not a bad idea to put at least some money in a Roth 401(k) to give yourself more flexibility in managing withdrawals come retirement time. (For those of your reading this whose employers don't offer the Roth 401(k) option, you should consider a Roth IRA.)

As to how much of your retirement savings should go into a Roth 401(k) and/or Roth IRA, I don't think there's a way to arrive at an exact percentage. The more likely you are to be in a high tax bracket at retirement, the more you'll want to have in a Roth 401(k) and/or Roth IRA. Even if it were possible, however, I don't think it would be wise to have all your money in Roth accounts since that would suggest the Roth option is without question the better deal. And I don't think very many people can know that for sure.

So I wouldn't agonize over a precise breakdown. The most important thing is to have enough money in both regular and Roth accounts so that you leave yourself a decent amount of wiggle room when making withdrawals during retirement. If you can manage your retirement savings regimen enough do that, you'll do just fine.

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For Ask the Expert's "Hedge CDs, avoid interest rate sting," click here.

To find out how spouses with different financial habits can work together toward a common goal, click hereTop of page

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