A different way to invest for retirement: a Roth 401(k) option

Most people are familiar with traditional 401(k) plans, but many aren't familiar with an alternative way to invest for retirement: a Roth 401(k) option.

A study by Aon Hewitt found that only 11 percent of those who have Roth 40 1(k) accounts make regular contributions to them. This is hardly surprising, because various studies show that most participants in traditional 40 1(k) plans under-contribute to them, limiting the growth of their retirement nest eggs.

As you develop your retirement planning strategy, a Roth 401(k) is worth considering if your company's 401(k) plan provides this option. To understand the ideal use of a Roth 401(k), you must know the similarities and differences between them and traditional 401(k) accounts.

Perhaps the best thing about many companies' 401(k) accounts - traditional and Roth - is company matching money. Though not all companies do this, many contribute a fraction of a dollar for every dollar yon contribnte to yonr acconnt (some companies - precions few - match employee contributions dollar for dollar) up to a certain amount. As many people vastly under-contribute to these plans, they miss out on this free money.

With traditional 40 1(k) accounts, you don't pay taxes now on the moneyyou contribute. Instead, you're taxed on your contributions and earnings when you withdraw money in the future - ideally, not until you retire.

With a Roth 40 1(k), taxation works the opposite way. You must pay taxes on your contributions in the years that you make them. But when you make future withdrawals, there's no tax due on your deposits and earnings as long as you're at least 59½ and you've had the account for at least five years.

One reason that traditional 401(k)s are popular, aside from matching money, is that many people expect to be in a lower tax bracket when they retire, so the tax deduction now on contributions can be highly beneficial. But with people living longer and retiring later, many can benefit from having the taxes on these retirement accounts out of the way by the time they're in their 60s. With a Roth 401(k), they can do this.

One of the biggest advantages of a Roth 401(k) is that because you've already paid all the taxes in the years that you make contributions, eventual withdrawals can be 100 percent taxfree versus 100 percent taxable for a traditional 401(k) account.

As younger people may be earning less money now than they hope to later in life, they should consider investing in a Roth 401(k) now and thus pay taxes on their contributions at their current low tax rate. Upon retirement - after they reach 59½ - they can withdraw money without paying any taxes when their incomes, and thus their tax rates, may be higher.

A 30-year-old with a Roth 401(k) could have 17 percent more spendable income in retirement than with a traditional 401(k), assuming that his or her pre- and post-retirement tax rates are the same, an analysis by T. Rowe Price concludes. Further, this analysis showed that when people retire at a tax rate comparable to the one they were in when they were working, a Roth 401(k) can give them significantly more spendable income than a traditional 401(k).

Many couples may be in a lower tax bracket in retirement than during their peak earning years. For anyone currently in a high tax bracket, a traditional 401(k) account - which provides a tax deduction now - may be the better choice. Splitting contributions between both a traditional 401(k) account and a Roth account may be a good tax diversification strategy, depending on your situation.

When planning for your retirement income streams, be sure to carefully consider all options - including a Roth 401(k), if your company's plan makes it available. Though you should never forgo employer matching money in 401(k) plans, you also don't want to overlook the importance of projecting the differences in spendable income during retirement from a Roth versus a traditional 401(k) account.

This content is based upon information believed to be accurate by ISI Financial Group Inc. However, it should not be relied upon for legal or accounting purposes. Past performance is not indicative of future performance. Investments involve risk, including the possible loss of principal. Always seek professional advice before making any financial or legal decisions.

Tim Decker, a fee-only financial planner, is president of ISI Financial Group in Lancaster. He is the author of "The SleepWell-At-Night Investor" and host of the radio program "Financial Freedom," which airs at noon Saturdays on WHP-AM 580. Contact him at www.isifinancialgroup.com.

Tim Decker president of ISI Financial Group