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When a Roth 401(k) Makes the Most Sense

Dan Caplinger
May 21, 2013

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