It has become more common for employers to offer not only conventional 401(k) retirement plans, but, since they became available in 2006, also Roth 401(k) plans.
For 2009, an employee can put away a total of up to $16,500 in a 401(k) plan. If the employee is at least 50 years old or will be before the end of the year, the maximum contribution rises to $22,000 because of a “catch-up” contribution of up to $5,500. The total contribution may be allocated between 401(k) and Roth 401(k) accounts. In fact, the prevailing view is that it is a good idea to have some money in both types of plans because doing so will yield benefits from a diversified exposure to taxes.
From an income tax standpoint, a 401(k) and a Roth 401(k) are mirror images. Contributions to a traditional 401(k) come from pretax earnings, and tax is deferred on that money and the income earned by the account until money is withdrawn. By contrast, a Roth 401(k) is funded up front with taxable earnings, but then all withdrawals are tax free after the account exists for 5 years and the account holder reaches the age of 59 1/2.
If the tax bracket were to stay constant throughout a taxpayer’s working life and into retirement, there would be little or no financial advantage of one plan over the other. In most cases though, either through changes in the Tax Code or due to changing income levels, or both, over the years a taxpayer moves among the various tax brackets. The direction in which the taxpayer is headed on this scale largely determines whether a conventional 401(k) or a Roth 401(k) makes more sense.
If you anticipate that your tax rate is now higher than it will be in the future, a traditional 401(k) is probably the right choice. A typical example involves the person nearing retirement who is currently in the last few peak earning years, but who soon expects to have lower income during retirement. On the other hand, a young adult worker just getting started may well be in higher tax brackets in later years, making the Roth 401(k) more attractive. For that individual, the future tax free withdrawals from the Roth 401(k) will bring greater benefits.