A Roth 401k Overview

Since the early 1980s, workers have been able to contribute to 401k accounts on a pre-tax basis-their taxable income is reduced by the amount contributed--with the assumption that by the time they retire and owe taxes on the contributions and earnings they would be in a lower tax bracket. But since that time, the top federal tax rate has fallen from 70% to a current 35%. So the likelihood of your being in a lower tax bracket during retirement has been greatly reduced.

The Potential Roth Advantage

There are a number of advantages to a Roth 401k including:

A Lower Tax Bill on Your Nest Egg Once You Retire: Many 401k participants may have a choice of contributing to a Roth 401k, in which you pay taxes on the income contributed today in exchange for withdrawing MOST OF the earnings tax-free at retirement-instead of or in addition to a regular 401k account.

Who would benefit from the Roth 401k? Those of us who expect to earn a significantly higher salary right before retirement than we are earning now-which is most people who still have many years of work ahead of them. Here's why: for people who contribute to a 401k account for most of their career, anywhere from 50% to 75% of their nest egg is going to come from investment earnings. With the Roth option, you will owe Uncle Sam nothing on years of compounded profits. On the other hand, with traditional 401k accounts, while you postpone taxes in order to have more spending money today, once you start withdrawing from your nest egg at retirement you pay taxes at ordinary rates-not just on your contributions but also on all of the compounded earnings on them.

Tax Diversification: No one expects certainty in tax laws, as it is a given that they are always changing. In a world of uncertain future tax rates, you might want to consider tax diversification. Just as you invest in different types of assets to diversify investment risks, so you should hold Roth savings to diversify the risks associated with pre-tax savings. Remember, there is no guarantee that you will be in the same or lower tax bracket during your retirement years.

You May Avoid Some Taxes on Social Security Benefits: Unfortunately, the more money we earn, the more taxes Uncle Sam will want to deduct from our Social Security checks. While Social Security benefits are usually tax-free for low- and many middle-income retirees, they gradually become taxable as a retiree's non-Social Security income increases. For some middle-income and most upper-income retirees, each dollar of pre-tax income triggers not only a higher federal income tax, but a faster rate at which Social Security benefits become taxable. This is another reason why paying taxes upfront with a Roth 401k could result in a big tax advantage.

Death and Taxes May Be Certain But Tax Policy Isn't So It's Wise to Diversify

Tax policy in the future is about as predictable as the weather. The very law that brought Roth 401ks into being--The Economic Growth & Tax Relief Reconciliation Act of 2001 expires at the end of 2010 and it's anyone's guess whether Congress will extend the Roth provisions beyond that time. For that reason, in the same way that it's a good idea to diversify the assets in your 401k account to lower your investment risk, you might want to consider "tax diversification"-that is, splitting your contributions between a Roth and a "regular 401k. Let's face it, there is no guarantee that you will be in the same or lower tax bracket during your retirement years-or that Congress won't tweak tax brackets again.

Do Your Homework Before Making a Decision

Consult with your plan administrator: There are some additional requirements and rules for Roth 401k plans that we don't have the space to cover here.

Consult a tax expert: While Roth 401k plans can offer substantial tax savings, there are some cases when contributing to one can put you in a higher tax bracket, which may result in losing out on other tax breaks. For example, switching to a Roth 401k may boost your family's taxable income enough to make your household ineligible for certain credits; for example, the Child Tax Credit.