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.