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When a Roth 401(k) Makes the Most Sense

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If the idea of tax-free growth throughout your lifetime sounds attractive to you, then using a Roth 401k could be one of the most valuable parts of your retirement savings strategy. But given all the other choices you have with the money you're setting aside for retirement, figuring out when a Roth 401(k) is your best option can be complicated.

Whenever you have to consider tax issues in your investing, things can get complex in a hurry. But when you step back and consider the basics of the Roth 401(k) and how it works, there are some simpler guidelines you can use to decide whether the plans are right for you.

The basics of the Roth 401(k)
Most Americans are familiar with the traditional 401(k), in which you're allowed to put money into an employer-sponsored retirement account on a pre-tax basis. By contributing to a regular 401(k), you're able to reduce your current-year taxable income, giving you an immediate reduction in the amount of tax you pay. With contribution limits this year of $17,500 for those under age 50 and $23,000 for those 50 or older, the tax savings from using a traditional 401(k) can amount to thousands of dollars.

By contrast, the Roth 401(k) works differently. Rather than using pre-tax money, contributions to a Roth are done on an after-tax basis, meaning that you don't get any upfront tax savings from putting money in the Roth. But in exchange for giving up the current-year tax break, you get what could be an even more valuable benefit: You'll never have to pay taxes on the income your Roth 401(k) produces, even when you withdraw it from the account in retirement. By contrast, with a regular 401(k), you do have to pay tax at your normal income-tax rate when you make withdrawals in retirement.

So when is the Roth 401(k) a smart move?
Another way to look at the pre-tax versus after-tax issue is to ask yourself a question: What is your current tax bracket, and what's your tax bracket likely to be after you retire? If you're in a high tax bracket right now and expect your taxes to be lower in retirement, then the value of the upfront tax deduction is more than the taxes you'll save after you retire. In this case, Roth-style retirement-plan accounts aren't as valuable as a regular retirement plan.

But if you're current tax rate is relatively low compared with what it could be later in your lifetime, then a Roth 401(k) makes a lot more sense. Essentially, a Roth 401(k) lets you lock in the tax rate you're paying now, forever removing the money inside the account from whatever tax rates may prevail in the future.

In particular, three sets of people should take a close look at Roth 401(k) options:

  • Young adults. Usually, people have the lowest income when they're just starting out in their careers, and therefore, their income-tax rates are likely to only get higher as their income rises. As attractive as a small tax break might be, using a Roth 401(k) is usually a better choice, as it lets you take advantage of those low rates while you have them.
  • Workers with substantial assets in taxable or non-Roth retirement accounts. At the other end of the spectrum, a Roth 401(k) can make sense even if you're not in a low tax bracket right now. Wealthy people can't expect to see their tax rates go down in retirement, as the amount of taxable income they'll have from investment income and regular IRA and 401(k) distributions will probably keep them in top tax brackets even when they stop working. For them, locking in a high tax rate with a Roth 401(k) may be preferable to leaving yourself exposed to the even higher tax rates that could prevail in the future.
  • Those who want to hedge their tax bets. If you're able to set aside a substantial amount toward your retirement, using a mix of Roth and regular 401(k) accounts and IRAs will give you the best of both worlds: some tax savings now along with some tax-free growth to provide benefits in the long run.

That last option can actually work well with a diversified portfolio. For instance, Vanguard Total Stock (NYSEMKT: VTI  ) , iShares MSCI EAFE ETF (NYSEMKT: EFA  ) , and other high-growth-potential investments can produce the most tax savings in a Roth, while iShares Core Bond (NYSEMKT: AGG  ) , Vanguard Total Bond (NYSEMKT: BND  ) , and other taxable income-oriented investments can fit well in a traditional retirement account.

Give the Roth 401(k) a chance
Regardless of how you choose to invest, consider the Roth 401(k) if it's available in your employer's retirement plan. Escaping the tax man for life could well be worth the price of giving up a modest tax break now.

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Read/Post Comments (12) | Recommend This Article (16)

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 May 22, 2013, at 12:49 AM, herky46q wrote:

    It is guessing game, and because of the uncertainty, I think the sure thing of the tax deduction now is a safer bet.

  • Report this Comment On May 22, 2013, at 3:24 PM, Calimesa wrote:

    Maybe I over simplify too much but let's just say for argument that you're in the 30% tax bracket now and you expect to be in the 20% tax bracket when you retire and start to draw on your 401(k) or IRA. Wouldn't you rather pay 30% tax your $100 now by contributing to a Roth account versus paying 20% tax on your $300 when you start drawing from a Traditional account? Of course that's assuming you triple your $$$ over the course of 25-50 years which I think isn't impossible. Please let me know what you think.

  • Report this Comment On May 22, 2013, at 6:08 PM, plankton97 wrote:

    Calimesa - using your numbers, wouldn't it be better to do the traditional IRA? I could put the full $100 in now and have $300 later, on which I would owe $60 in taxes when I withdrew it, so I'm left with $240 at retirement. With the Roth, I pay 30% up front, so I only have $70 to put in now and have $210 at retirement. Am I missing anything?

  • Report this Comment On May 22, 2013, at 6:09 PM, dotdashdot wrote:

    You forgot the added benefit of a Roth in that it can be inherited by your heirs tax free. Not so with a 401k plan or personal IRA.

  • Report this Comment On May 22, 2013, at 9:03 PM, wolfman225 wrote:

    Problem is, can we count on the government not to change the rules governing retirement accounts when they determine a need for increased revenue? I have my doubts. Factor in the likelihood that any change would be retroactive...... I'll stay with my 401k for now, at least until I max out. If we ever get an administration we can trust, I may reconsider.

  • Report this Comment On May 23, 2013, at 11:37 AM, rahj2001 wrote:

    Wolfman....you point is very valid. Its a crap shoot and in the end its a subjective situation.

  • Report this Comment On May 24, 2013, at 1:22 PM, stlmikey wrote:

    Assuming the tax rate is the same going in as coming out, the two plans are mathematically equivalent. The problem is we don't know what the tax rates will be coming out. This argues for tax diversification just like we should have investment diversification. Dan made most of these points. Roths have several advantages including the ability to get contributions back without taxes at any age and the ability to pass on tax free to heirs.

    I suggest that Roth accounts should make up 10% to 25% of total retirement assets. In the withdrawal stage, moneys should come from taxable accounts until you have filled up the lower tax rate buckets (currently 10% and 15%) and then consider switching to Roth distributions so you never pay taxes at a 25% rate.

    While the tax situation could change, I think it is extremely unlikely that Roths would be taxed retroactively unless an equally unpalatable change was made to regular IRAs/401Ks.

  • Report this Comment On May 24, 2013, at 1:23 PM, skrunge13 wrote:

    Plankton97. Either way you put $100 into your account. Putting the $100 into a Roth will effectively cost you $130 at time of deposit. Subtracting the $30 from the end result of $300 leaves you with $270 not $240. To compare the example correctly you need to start with the same principal.

  • Report this Comment On May 24, 2013, at 2:25 PM, Calimesa wrote:

    Plankton97, kind of, my premise is that you put $100 in and pay the $30 tax out of your cash account (not take the $30 out of your $100 contribution) so in effect you're choosing whether you want pay $30 tax now or $60 tax later.

    Another way of stating I'm saying (assuming the tax rate I initially stated):

    Traditional Acct - $100 tax free contribution, at point X in the future it's worth $300 so you pay $60 in tax on the distribution.

    Roth Acct - $100 taxable contribution you pay $30 now, at point X in the future it's worth $300 and you take it as a non-taxable distribution.

    Who really wants to pay 100% more in taxes than they need to? Of course this is in the simplest of terms, I believe that paying tax on a small sum is better than paying tax on a large sum.

  • Report this Comment On May 31, 2013, at 6:08 PM, 123spot wrote:

    Is it true that unlike a "Roth", a "Roth 401 k";

    1)requires minimum distributions at 70?

    2)can be contributed to regardless of high income?

    3)cannot be inherited tax free as a poster above may have suggested?

    Thanks for the valuable article Dan, and to anyone who can answer these questions. Spot

  • Report this Comment On July 01, 2013, at 7:32 PM, sonofagunk wrote:

    Calimesa, there is a problem with your logic. The issue is that at Time X, the money in the traditional account will have 300 (100*3), and then after tax, you have 240. But in the other account, at time X you will not have 300, you will only have 210 (70*3) since all of your investments will triple at time X (be nice if everything always tripled). With that said, Roth is still good since tax rates have no where to go but up

  • Report this Comment On July 01, 2013, at 7:37 PM, sonofagunk wrote:

    Another place Roth 401K is good is when you are already maxing out your 401K but want to put in more. Of course you can only put 17.5K right now in both accounts COMBINED, but if you are putting $17.5K after tax in the Roth, that is worth more than $17.5 pre tax in the traditional 401K.

    If you do not believe me, picture one person putting 17.5K in a traditional and another putting it in a roth. Themarket is flat for a year, and the both pull their money (they retired and are over 60). The person who put the money in the regular 401K, will take out and pay tax on 17.5K, so he will have less. The other guy will have 17.5K. Of course the first guy will have more take home during the year they work, but that is not the point. The point is that you can get more into retirement by maxing out your Roth vs maxking out a regular 401K

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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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