There's never a convenient time for taxes. But for twentysomethings who are saving for retirement, paying tax on contributions now, rather than later, may be the best alternative.
In August, President Bush signed the Pension Protection Act, which made permanent the option for employers to offer a Roth 401(k) or Roth 403(b). Like the Roth individual retirement account, around since 1997, contributions to a Roth 401(k) are made after tax. Earnings and withdrawals in retirement are tax-free.
In contrast, with a traditional 401(k), you make contributions to the plan before paying income tax, thus reducing your near-term tax bill. But while your earnings grow tax-free, the money you withdraw during retirement is taxable.
Many of us would benefit from having a little more cash today. Young workers especially may be tempted to delay facing the tax bill until 40 years from now.
But there is a strong argument that you'll come out ahead if you pay now. Why?
"Income tax rates are at historic lows," said Rick Meigs, president of 401kHelpCenter.com, an online resource for both 401(k) administrators and participants. "What is the probability that in retirement you're going to have a lower tax bracket than you have today? It's not high."
One reason tax rates could go up: Once Baby Boomers begin to retire, the number of workers who pay taxes will start to drop, while demand for taxpayer-funded services such as Medicare will climb sharply.
To meet demand, taxes as a percentage of gross domestic product may have to rise by as much as one-third, "with more increases to follow," according to a speech that Federal Reserve Chairman Ben Bernanke made this month.
The bottom line: For anyone in a low tax bracket today, you may be better off investing through a Roth 401(k).
But before you jump into a Roth 401(k), here are a few things you'll need to know.
-- Not all employers offer Roths--yet
Introduced in January, Roth 401(k)'s are available only in less than 10 percent of companies, according to David Wray of the Profit Sharing/401k Council of America.
But now that the feature has been made permanent (the Roth originally was set to expire in 2010), that number is expected to grow.
Keep in mind that the Roth 401(k) is a feature of your employer's retirement plan, not a distinct account. When you participate in a Roth 401(k), you simply designate that you'd like to start paying taxes up front--there's no need to set up a new account.
"The employer bears most of the additional work," said Meigs, of 401kHelpCenter.com.
Also, if your employer provides a match, those dollars are deposited pretax, meaning they must go into your traditional 401(k), not the Roth.
-- A blend of rules
Like a Roth IRA, you can't tap your savings in a Roth 401(k) before five years. You can, however, contribute up the maximum allowed for 401(k)'s annually, which in 2006 is $15,000 for employees younger than age 50. In the Roth IRA, the maximum contribution is $4,000.
There also is no income limit for the Roth 401(k), and you can take the same loans or hardship withdrawals that are possible with a traditional 401(k).
Want more information? American Funds' Retirement Center (www.americanfundsretirement.com) gives a point-by-point comparison of Roth and traditional 401(k)'s (Look under the Pension Protection Act link, and click on the Roth 401(k) link on the left side).
E-mail Carolyn Bigda at firstname.lastname@example.org.