Many large employers have started offering employees the choice between a traditional 401(k) and a Roth 401(k). However, only a small percentage of employees have elected to contribute to a Roth 401(k). The primary difference between the two plans is when you pay income taxes. When you contribute to a traditional 401(k) your contribution is currently tax deductible, but you must pay regular income taxes on distributions taken in retirement. Contributions to a Roth 401(k) are not currently deductible, but you pay no income taxes on distributions in retirement. As with your traditional 401(k), your employer can match your Roth 401(k) contributions, but the match must go into a pre-tax account.
There are several differences between a Roth 401(k) and a Roth IRA. In 2014, annual contributions to a Roth IRA are limited to $5,500 plus a $1,000 catch-up contribution if you are 50 or over. Contribution limits on Roth 401(k) plans are much higher at $17,500 plus a $5,500 catch-up contribution, if you are 50 or over. Additionally, there are income limitations on your ability to contribute to a Roth IRA, and there no income restrictions on contributions to a Roth 401(k). Additionally, upon reaching 70 ½ you must take a required minimum distribution from a Roth 401(k). You are not required to take a distribution from a Roth IRA at 70 ½. However, you do have the option to transfer your Roth 401(k) to a Roth IRA prior to 70 ½ to avoid this requirement.
The decision on whether to invest in a Roth or traditional 401(k) depends primarily on when you want to pay taxes. If you are currently in a low tax bracket and believe you will be in a higher tax bracket in retirement, a Roth account may be your best option. On the other hand, if you are currently in a high tax bracket and you think you may be in a lower tax bracket in retirement, a traditional 401(k) could be your best option. A Roth 401(k) is generally most appropriate for younger investors who are just getting started in their careers or someone who is experiencing a low income year. People who are in their prime earning years may be better off taking the current tax deduction available with a traditional 401(k).
Unfortunately, it’s difficult for most of us to know if our tax bracket will increase or decrease in retirement. It is also hard to know if tax rates will increase before we reach retirement. From a historical perspective, tax rates are currently low and some believe future rates will be increased to help cover the rising federal debt. Amid this future uncertainty, your best option may be to split your contribution between a Roth and traditional 401(k). This will give you some tax relief today and some tax diversification in retirement.