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.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.