Many companies have been adding the Roth 401(k) option to their retirement plans since they became available in 2006. Unfortunately, few participants take advantage of it. If you dismiss contributing to a Roth 401(k), it could cost you years of potential tax savings when needed most – during retirement.

According to Wells Fargo, only 12% of 401(k) participants contribute to the Roth option

Sure, the Roth 401(k) isn’t for everyone, but you can be sure it benefits more than 12% of participants. Why the meager participation rate? It’s called human nature. If you don’t understand how something can benefit you, it’s easy to ignore.

The Roth 401(k) – delayed gratification

The traditional 401(k) provides an immediate tax benefit. Contributions are made with pre-tax dollars, reducing your taxable income. All growth is tax-free. In retirement, however, withdrawals are taxed as income.

The Roth 401(k) is funded with after-tax dollars and will not reduce your tax bill at the time you contribute. Contributions grow tax-free, like a traditional 401(k), but withdrawals from Roth 401(k)s are tax-free if you’ve had the account for five years and are at least 59½.

We weigh current benefits more heavily than future benefits. It’s harder to grasp the future advantages of the Roth 401(k). Since each option provides tax-free growth, why does it matter if you’re taxed now or in retirement? It may make thousands of dollars of difference.

Income needs and sources

Most retirement income comes from traditional 401(k)s or IRAs, Social Security, and pensions. 401(k)s, IRAs, and pensions are all taxable as income. Social Security is a bit more complicated.

Social Security

If 1/2 of your Social Security benefit plus your distributions from 401(k)s, IRAs, and pensions are above two very low thresholds, then either 50% or 85% of your Social Security benefit is taxable.

Roth distributions, on the other hand, do not count towards determining the taxability of your Social Security benefit. The savings will add up if you can keep even a few years of your Social Security benefits tax-free during retirement.

You also need to consider when to begin taking Social Security. Read more about that here.

Medicare Premiums

Your income determines the monthly premium you’ll pay for Medicare. We’re not talking pennies here, either. The difference could be hundreds of dollars PER MONTH!

You guessed it, distributions from 401(k)s, IRAs, and pensions count towards that calculation. Roth 401(k) distributions do not. Look at Medicare.gov to see how much you can save by reducing your taxable income.

The income tax change of life

I see it happen every year. Those individuals and families close to or in retirement start to go through the tax change of life.

• The kids have moved out – no dependents (you hope)
• No credits: All of those credits on your 1040; tuition, student loan interest, etc. often disappear
• Fewer deductions: No mortgage interest (I hope), less state/local income taxes, no job expenses – you may have the standard deduction. You may not even be able to write off charitable contributions.

Even though you may require less income in retirement, you’ll likely have fewer tax-reducing credits and deductions. That sometimes offsets the reduced income, and you end up in the same tax bracket.

That is if your distributions are taxable. The Roth 401(k) shines here as well. It’s not counted as income, so you can be sure your tax rate will be lower regardless of your deductions and credits.

The required minimum distribution rules

Required minimum distributions (RMDs) begin when you turn 73. Starting in 2024, RMDs will only apply to a traditional 401k. Finally, Roth 401ks will match the Roth IRA rules and not be subject to RMDs. You won’t have to go through the extra steps of avoiding RMDs by rolling the Roth 401k into a Roth IRA.

Most people still roll their 401k into their IRA and Roth IRAs for better diversification. Be aware when you move a Roth 401(k) to a brand-spanking new Roth IRA, there will be a five-year waiting period before you can withdraw qualified distributions. However, the rollover will assume the same holding period for those with a Roth IRA already in place.

Rules of thumb vs. reality

If you know your retirement tax rate will lower, then a traditional 401(k) is the way to go. You’ll now reduce your taxable income at a higher tax rate and withdraw in retirement at a lower rate.

If you think you’ll have the same or higher tax rate during retirement, a Roth 401(k) might be the better choice. You’re paying taxes upfront at a time when your tax rate is lower and avoiding taxes during retirement when your tax rate may be higher.

Hedge your bets

No wonder the Roth 401(k) is not popular. It comes down to assumptions, speculations, and predictions. Luckily, deciding between a Roth and a traditional 401(k) contribution is not an either-or choice. Both probably will be appropriate in different measures throughout your retirement saving career.

If you’re young and just starting your career, save for retirement in a Roth 401(k). Every year, you get a raise, try to bump up your 401(k) contributions. If your income pushes you into a higher tax bracket, increase contributions to the traditional 401(k) for some tax benefit.

For those in mid or late careers, it’ll take some tinkering. You might be 50% traditional 401(k) and 50% Roth 401(k), or 75%/25%, 90%/10% or anywhere in between. There is no one formula for everyone, and each individual’s formula will change every so often.

The Roth 401(k) ace in the hole

Most people should put some savings in a Roth 401(k) at some stage. It’s like your emergency savings in retirement. You may not need it every year, but it’s good to have that ace in your back pocket, just in case.

Have you ever wondered if contributing to a Roth 401(k) was for you? Have you ever experienced analyzing this decision? I’d love your thoughts or questions on the Roth 401(k).