Don’t miss out on the Roth 401(k)’s tax-free withdrawals

More and more workers have a choice in their retirement plan — to put their savings in a traditional 401(k) or a Roth 401(k).

The problem: Many people don’t know they have this option, and those who do often don’t have any idea which to pick. As a result, few workers are choosing the Roth 401(k), even though many could benefit from it.

Of the 1,900 employers offering 401(k) plans through Vanguard Group, 56% give employees access to a Roth 401(k), up from 42% in 2010. Large companies are likeliest to offer Roths, so more than 2.3 million workers in Vanguard plans, almost two-thirds of the total, have access to Roth 401(k)s. But new Vanguard data show just 14% of them are using a Roth, a number that has slowly risen from 9% in 2010.

With a traditional 401(k), you pay no taxes on contributions. Instead, you pay taxes when you withdraw the money in retirement. A Roth reverses that: There’s no tax break on contributions, but all withdrawals — including any investment gains — are tax-free.

Deciding between a Roth and a traditional 401(k) isn’t easy, and even experts disagree on how helpful Roths are. “Situations vary so much that it’s hard to make blanket statements,” says James Choi, a finance professor at the Yale School of Management.

Still, a Roth plan offers advantages for many retirement savers. It’s generally a more flexible tool than a traditional 401(k), for example. And for many younger and lower-paid workers, a Roth plan is a no-brainer.

“More people should be using it,” Vanguard senior research analyst Jean Young said.

That’s why, since a 2006 law allowed the creation of Roth 401(k)s, more employers have been offering them. Workers have been signing up, but quite slowly. Most people are confused by Roth plans, says Chad Parks, chief executive officer of Ubiquity Retirement and Savings, a 401(k) provider for small businesses. “It’s not an easy thing to grasp.”

Here are some pros and cons of Roth 401(k) plans.

PRO: A TAX BREAK FOR THE YOUNG AND POORLY PAID

With a Roth, workers trade some upfront pain for a long-term gain. They pay taxes on their retirement savings now so they don’t have to pay taxes on withdrawals in retirement. The young benefit most from this strategy, because they have more time to let their money grow tax-free.

Also, any worker with low to moderate income should use Roths if she expects to earn significantly more later in her career. She’s in a low tax bracket now, which minimizes the upfront pain of a Roth. The Roth will then help her avoid taxes in retirement, when she’s in a higher tax bracket.

CON: THE TAX BENEFITS CAN BACKFIRE

A Roth makes little sense for certain higher-paid, older workers. They’re paying high tax rates now, and a traditional 401(k) gives them a break.

A Roth also doesn’t work well for workers who didn’t plan well for retirement. If you’ll be poorer in retirement, your taxes will be low then anyway. While you’re still working, you might as well take the traditional 401(k)’s tax break and save as much as you can in it.

PRO: FLEXIBILITY IN RETIREMENT

The wealthy can still benefit from a Roth 401(k), because of the flexibility it offers. For example, a retired couple wants to splurge on a $40,000 round-the-world cruise. If they take that money from a traditional retirement account, they’ll need to pay taxes on it. That one-time expense may bump them up to a higher tax bracket. But any withdrawals from a Roth 401(k) are tax-free, so retirees can cover big expenses without worrying about the tax consequences.

Another way Roth accounts are more flexible than traditional ones: By law, retirees must make regular withdrawals — “required minimum distributions” — from their traditional retirement accounts after age 70 and a half. But retirees can leave assets in a Roth account for as long as they want. That can keep investments growing tax-free well into retirement.

CON: THE RIGORS OF TAX PROGNOSTICATION

No one knows for sure what the U.S. tax system will look like in five years. Predicting tax rates in 30 or 40 years is just about impossible. Roth plans could end up being a bad deal if lawmakers eventually lower income tax rates and replace them with value-added or sales taxes. Roths would become a better deal, though, if the income tax burden on seniors goes up. The higher that income taxes are on retirees, the more benefit a Roth account provides; the lower they are, the more a traditional plan makes sense.

Of course, the uncertainty about future tax rates is also a good argument for hedging your bets by using a mix of both Roth and traditional accounts.

PRO: FLEXIBILITY BEFORE RETIREMENT

If you withdraw money from a traditional 401(k) plan before you turn 59 and a half, you pay both taxes and a 10% penalty. There’s no penalty for withdrawals from a Roth 401(k), as long as you take back only the amount of your original contribution and leave any earnings in the 401(k). That can make a Roth account valuable in emergencies or if you retire early.

Then again, for savers without much willpower, Roths can make it tempting to blow through retirement money too early.

CON: TAX CREDITS AND THE AMT

If you’re poor enough, a traditional 401(k) can lower your taxable income and may help you qualify for benefits like the Earned Income Tax Credit. If you’re wealthy, the choice between Roth and traditional plans can affect whether you’re subject to the alternative minimum tax, or AMT. The AMT is an alternative tax system that limits the deductions wealthier taxpayers can take. Because the AMT is extraordinarily complex, a Roth can either trigger the AMT or help taxpayers avoid it, depending on their circumstances. If an AMT is a possibility for you, a tax accountant may be able to tell you which retirement plan to choose.

PRO: A HIGHER SAVINGS LIMIT

Workers under age 50 can save up to $18,000 in a 401(k) account every year. Past age 50, they can save an extra $6,000.

Those limits are the same for Roth and traditional accounts, but any after-tax dollars put in a Roth go farther, because you still owe taxes on any money put in a traditional account. That makes Roth plans a nice option for workers who want to put as much money in their retirement accounts as possible.

CON: EMPLOYER MATCH FORMULAS

Companies match their employees’ contributions to retirement plans in dozens of different ways. But generally, the more an employee contributes, the more an employer kicks in. And, because it’s easier to save in pretax dollars than in post-tax dollars, it may be possible to get more matching dollars out of your employer with a traditional account.