(Bloomberg Business) — 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, very 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 percent give employees access to a Roth 401(k), up from 42 percent 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 percent of them are using a Roth, a number that’s slowly risen from 9 percent 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,” said James Choi, a finance professor at the Yale School of Management.
That said, 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 very slowly. Most people are confused by Roth plans, said 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 theirretirement savings now so that 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 incomes should use Roths if they expect to earn significantly more later in their careers. They’re in a low tax bracket now, which minimizes the upfront pain of a Roth. The Roth will then help them avoid taxes in retirement, when they’re 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.