Since its inception in 2006, the Roth 401k account has been growing in popularity as a retirement plan option offered by employers. With the passage of the American Tax Payer Relief Act in 2012, the door has been opened even further for plan participants to convert all or a part of their vested, pretax, account assets into a Roth account.

Currently, about half of employer-sponsored plans include a Roth 401k provision. Here’s the 411 on the Roth 401k and why plan sponsors may want to consider it as a plan option:

How a Roth 401k Works

As with the Roth IRA, the Roth 401k allows retirement plan participants to make contributions on an after-tax basis, which then allows them to withdraw their Roth assets on a tax-free basis at retirement (age 59½ or later). The Roth 401k offers additional flexibility for withdrawals, allowing participants to take them if their Roth account has been established for at least five years.

For decades, 401k plans have attracted participant contributions based largely on the ability to shelter the income being contributed from current taxes. The earnings accumulate tax deferred, and then the amount withdrawn at retirement (including employee and employer contributions and earnings) is taxed as ordinary income.

Although Roth 401k contributions are made with after-tax dollars, the ability to accumulate account earnings tax-free, and then withdraw them tax-free is gaining wider appeal with more people become concerned with maximizing their retirement income.

Who Benefits from a Roth 401k?

Plan sponsors seeking to broaden the appeal of their retirement plan offering should consider adding a Roth 401k provision, especially if employee demographics support the option.

A Roth 401k option would be appealing to certain employees based on their current situation and anticipated financial needs. For example:

Young accumulators: Employees at the beginning of their careers and earning capacity generally pay taxes at a low rate and would not benefit as much from pre-tax contributions. They can still benefit from decades of tax-free compounding of their account earnings.

Pre-retirees concerned with high taxes in retirement: For individuals who have done well and saved a substantial sum for retirement, it may make tax sense to pay current taxes on earnings in anticipation of being in a high tax bracket in retirement.

Individuals concerned with estate planning: Because Roth 401k assets can be passed on to a spouse or children income-tax-free, it may make sense for individuals planning their estate. Roth assets can be passed to the next generation and continue to compound tax-free.

Individuals with big tax deductions or investment losses: For someone anticipating substantial tax deductions or investment losses, it may be a good time to convert their 401k assets to a Roth 401k. The taxable income created by the conversion will be offset by the deductions.

Of course, a Roth 401k is not for everyone. There will always be a certain segment of the employee population that can benefit more from the current tax savings available in a 401k plan. That’s why it is only offered as an option, to better serve the needs of those who would rather benefit from tax-free withdrawals.

A Minor Fix to Create a Major Enhancement

The good news is, thanks to the new tax law, adding a Roth 401k provision to your retirement plan is not administratively complex or expensive; however, it will require amending your plan and ensuring proper communication of the Roth 401k rules to employees.

The biggest consideration for employees is the taxable event caused by converting their 401k assets into Roth 401k assets. At the time of conversion, they will owe taxes on the assets created by pre-tax dollars from employee and employer contributions. Not only will they need to clearly understand the tax consequences of a conversion, they will need planning guidance to determine which plan option will be most suitable for their situation.