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The Roth 401(k): Your Best Tax-Fighting Tool

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For workers looking for a quick tax break on their bill next April, a Roth 401(k) isn't the answer they're looking for. But if you're willing to forego the instant gratification that a tax refund gives you, using your Roth 401(k) to maximize your retirement savings can save you a whole lot more in taxes after you retire.

Understanding the Roth
Roth 401(k)s haven't been around all that long, but their predecessor, the Roth IRA, was created more than 15 years ago. At the time, it marked a brand-new innovation in retirement saving. Until then, retirement savings was based on the concept of deferred compensation, whereby workers voluntarily chose to reduce their salaries by diverting money away from their paychecks toward retirement accounts. By reducing their current income for tax purposes, workers paid less in current-year taxes. In exchange, workers agreed to pay taxes whenever they decided to take money out of the account, typically after they retired.

By contrast, Roth IRAs allow you to contribute after-tax money to your retirement account. As a result, you don't get an upfront tax break, but you also avoid having to pay any taxes on your withdrawals after you retire. Given the amount of appreciation that you may earn in a lifetime of retirement saving, that can turn out to be a much better deal.

Roth 401(k)s: More of a good thing
One drawback of Roth IRAs, though, is that they have relatively low contribution limits. During 2012, those under age 50 can only contribute $5,000 to a Roth IRA, with those 50 or older eligible to add another $1,000. Moreover, those who earn more than the specified income limits under the tax code can't make any contributions to a Roth IRA.

Roth 401(k)s, on the other hand, have two big benefits in those areas. Contributing to a Roth 401(k) isn't governed by income limits, so anyone whose employer offers a Roth 401(k) plan to participate. Moreover, the larger contribution limits of 401(k) plans generally apply to the Roth version, with maximums of $17,000 in 2012 for those under age 50, and an additional $5,500 for those 50 or older.

Not all employers offer Roth 401(k)s, so the first thing you should do is check with your HR department to see if they're an option for you. If they are, then you should ask yourself several questions to decide whether they make sense for you:

1. Do you expect to pay more in taxes during retirement?
The current debate over the fiscal cliff has made many taxpayers anxious to lock in the relatively low tax rates under present tax law. If you believe that the tax rate you'll pay on your income will be higher when you withdraw money in retirement than it is now, then using a Roth 401(k) makes a lot of sense. But if you'd end up paying much a higher tax rate now than you will later, then a traditional 401(k) is a better bet, as it lets you defer taxes until whenever you choose to make withdrawals.

2. Is tax diversification valuable?
Even if you expect to pay higher taxes in retirement, having a Roth 401(k) as part of your retirement savings can be a smart move. Especially if you already have extensive traditional IRA and 401(k) assets, having part of your retirement money in an after-tax Roth gives you the flexibility of multiple pools of money from which to take withdrawals. Often, that can be extremely helpful with retirement tax planning, as traditional retirement account withdrawals can have an impact on how your Social Security benefits get taxed.

3. Do you want to use your Roth for estate planning?
Roth 401(k)s also have one other big benefit over regular retirement accounts: There's no requirement to take distributions during your lifetime. If you want to leave a legacy to your loved ones, a Roth can be the best way to get the job done, as your heirs will also enjoy the tax-free nature of distributions. That can lead to huge savings over multiple generations -- an almost perfect result from a tax-planning standpoint.

If you have access to a Roth 401(k), think hard about using it as a tool in your battle against the IRS to make the most of your retirement saving. With its unmatched potential for tax-free growth, the Roth 401(k) could make the difference between just getting by and having a financially secure retirement.

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Read/Post Comments (10) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 20, 2012, at 7:24 PM, JohnDeereBoy wrote:

    If you make over the income limit to contribute to a Roth IRA, contribute to an after tax, regular IRA then convert it to a Roth IRA the next day! (No income limit for the conversion).

  • Report this Comment On November 21, 2012, at 9:51 AM, VolBeast56 wrote:

    Can a self employed, or 1099er, like myself, start a Roth 401K? I currently have a Roth IRA, and a taxable account, but if I can increase my after tax contributions, I'd do it in a second.

  • Report this Comment On November 21, 2012, at 10:02 AM, openfool wrote:

    A few observations or questions if you will: Although I applaud this new type of savings vehicle, I think it is clearly geared toward high income earners, as in some plans you can contribute more than the IRS limit for traditional 401k's - I've seen some allow an additional 20K+ (though there is an IRS limit for any combination)

    Why would you contribute to a Roth 401k over a traditional 401k if you could only afford to do one or the other? Between 401k fees which are still dubious - what is the real benefit here? I would like someone to publish a cost benefit analysis of a Roth versus a traditional 401k over a 45 year career for median and high income earners (>= 250K). Paying taxes is not a bad thing, its what you keep at the end of the day. I'd rather draw 4% off a bigger pool of money, pay the tax and have more than draw 4% off a small pool of money - pay no tax and have less.

  • Report this Comment On November 21, 2012, at 2:15 PM, davaidesign wrote:

    One thing to keep in mind is that the "Roth" status isn't recognized outside the US, so if you plan on retiring abroad your savings will be hit with double taxation.

  • Report this Comment On November 24, 2012, at 1:28 PM, D119 wrote:

    Dan,

    Thank you for a very nice article.

    However, the following comment needs to be checked:

    "There's no requirement to take distributions during your lifetime" for a 401k.

    Roth 401k's may be subject to minimum distribution requirements even though Roth IRA's are not. This is an item to check on.

  • Report this Comment On November 25, 2012, at 6:10 PM, rrmcpa wrote:

    D119 - you are correct, Roth 401k balances are factored a retirees total RMD dollar amount, they are just not taxable.

  • Report this Comment On November 25, 2012, at 6:17 PM, bonsaibean wrote:

    As soon as my employer added the Roth 401K option, I updated my contributions to be split 50/50 between Roth and traditional 401K. I figured diversifying my taxation has to be a good thing, and I really like the idea of tax free growth forever. I think traditional IRAs & 401Ks are ticking tax bombs, and the tax hit when you start taking withdrawals may have a bigger effect than people are expecting.

  • Report this Comment On November 25, 2012, at 8:59 PM, D119 wrote:

    rrmcpa

    Thanks for the reply. There is one wrinkle that I haven't sorted out.

    If you start a 401k within 5 years of being 70.5 years old, then when you start taking out required minimum distributions, are you taxed on the withdrawals because you haven't had the account opened for 5 years?

  • Report this Comment On November 26, 2012, at 1:32 AM, herky46q wrote:

    I would rather have the tax advantage now, so I favor the traditional.

  • Report this Comment On November 27, 2012, at 4:02 PM, dianevin wrote:

    D119 - here's part of the puzzle. If you are still employed and don't own more than 5% of the company, then you don't have to take the RMD at age 70 1/2 - this is true for both traditional and Roth 401ks.

    A good thing to do is open a Roth IRA to get the 5-year clock running and then transfer the Roth 401k into it to avoid the RMD and also take advantage of that IRA's clock.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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