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Beginning in 2006, employers can offer their employees a choice in their 401(k) plan. Contributions by employees can either be made to a traditional 401(k) or to a new version, the Roth 401(k). The two types of plans are identical save one catch. With a traditional 401(k), the IRS doesn’t tax your contributions but any income you later take out is fully taxable. With a Roth 401(k), you don’t get the current tax break but all earnings are taken out tax-free. 

Why would you want to switch? If you pay a relatively low Federal tax rate currently and expect to pay more in the future, you would want tax-free earnings later when your taxes are higher. For instance, my effective tax rate last year was 8% after taking out child credits and itemized deductions. It’s unlikely that I would pay less than 8% tax in retirement, so a Roth 401(k) would be a good idea for me. 

Many employers did not offer Roth 401(k)s in the first year of eligibility (2006). There were several reasons, with a lack of IRS regulations on the workings of the new accounts being at the top of the list. With IRS regulations promulgated, more employers may offer the accounts in the next few years. It will still be more record keeping and more expense for the employer so I don’t expect Roths to catch on like traditional 401(k)s did, but there will be more than a few employers offering the accounts. 

One of the caveats with a Roth account is how investments will be taxed in the future. Unless Congress plans ahead [pauses for laughter] [no, really it could happen] [okay, better now?] you could be paying taxes to put money in a Roth and getting a tax break when earnings from investments are no longer taxed. That would effectively nullify the tax advantages of a Roth and would actually put Roths at a disadvantage to traditional 401(k)s. Now, I don’t really believe that earnings from investments will actually ever get to be tax free, but if it is something you think may happen in the future, you may want to hedge your bets and just use a traditional 401(k).

If you are an employee that does have a choice, The Tax Guide for Investors website has a great guide to Roth 401(k) accounts. It explains how the accounts work and how they differ from traditional 401(k)s and other types of retirement accounts. It’s definitely worth checking out for someone that is confused as to how they should allocate their contributions.