Love yourself some Roth 401(k)

As more U.S. workers start new jobs, they should take a closer look at their employers' options for retirement savings. An underused account called a Roth 401(k) could help minimize taxes in the long run and multiply how much savers eventually have.

Unlike a traditional 401(k), contributions to a Roth 401(k) aren't tax-deductible, but withdrawals are tax-free in retirement. A helpful way to think about it: With a Roth 401(k), the balance is what you'll actually get in retirement (since you've already paid income taxes on what's in there) whereas with a regular 401(k), a chunk of that balance will go to paying income taxes when you're retired and withdraw money from it.

Roth 401(k)s are a no-brainer when you're young, in a low tax bracket and expect to earn a lot more in the future. Sure, you won't get the tax deduction upfront, but it probably doesn't matter if you're not paying much in taxes in the first place. Plus, you're likely to more than make up for it given the tax-free growth in your investments over decades.

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But even some workers who are older and earning more should consider mixing it up and putting money into a Roth 401(k) too, especially given their higher contribution limits relative to traditional IRAs or Roth IRAs. Contributions to IRAs are capped at $6,000 ($7,000 for those 50 and over), while total 401(k) contributions can go all the way up to $20,500 ($27,000 for those 50 and up). Proposals under consideration in Congress would increase those 401(k) contribution limits even more for older savers and potentially treat them as after-tax.

Almost 80% of companies' 401(k) plans offered a Roth option as of June 30 compared with 62% five years ago, according to Fidelity Investments. But just 14% of workers who were offered one were contributing compared with 10% five years ago. Data from Vanguard shows a similar story: 77% of plans offered a Roth 401(k) option in 2021, but just 15% of workers were participating.

Part of the problem may be auto-enrollment. Many plans just default workers into traditional 401(k) plans. That's not a bad thing since it does encourage savings, but it would be better if employees were forced to make an active choice — especially given how much younger workers stand to benefit.

For higher earners, the conventional thinking has always been that a Roth 401(k) is pointless since they're likely to earn less in retirement and therefore be in a lower tax bracket (so pay less in taxes when they take money out). There are a few reasons why that's worth revisiting.

First, while you might feel confident that you'll be earning less in retirement, it's risky to assume tax rates in general will be lower. Personal income tax rates are relatively low now, and given the increasing federal deficit, there's a good chance they'll be heading north at some point in the future. Also, if you're in a high bracket now, you may still be in one even after you stop working thanks to other streams of income.

It's also prudent to give yourself different types of retirement accounts to tap, tax-wise. Then you have more flexibility around your taxable income, especially if you're concerned about hitting the thresholds for higher taxes on Social Security benefits or certain Medicare costs. You might contribute to both types of 401(k) accounts, or alternate which account you're contributing to from year to year.

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As with traditional 401(k)s, Roth 401(k)s require you to take a certain amount out each year once you hit 72 — called required minimum distributions — but with Roth 401(k)s, the money won't be subject to income taxes. There are also some ways around those distributions. If you're still working for your employer at 72 you may not have to take them. Alternatively, if you meet certain requirements, you can roll the balance over to a Roth IRA before turning 72 since Roth IRAs don't have distribution requirements.

If you're sold on the idea of a Roth 401(k), you can roll over some or all of your money from a traditional 401(k) to a Roth 401(k) in what's known as an in-plan conversion — but you'd better be sure, because there's no way to roll it back. Nonetheless, this is an especially good time to do a conversion, because your account has likely lost money amid the stock market downturn, so you'll pay less in upfront tax.
Still, there are some caveats. You'll be subject to taxes and a 10% withdrawal penalty if you take investment earnings (not your contributions) out of a Roth 401(k) before you've had the account for five years and if you're not yet 59 and ½. So avoid setting one up if you're planning to retire soonish and counting on that money.

Also: Employer matches. Most companies will match the dollar value of their workers' contributions up to a certain point, but they'll put that money into their regular 401(k)s, even if the employee is contributing to a Roth 401(k). So be aware that whatever your employer is matching, along with earnings, will be subject to tax in retirement. In that case, even with a Roth 401(k), you won't be able to fully escape the taxman.