The Roth 401k can be a tremendous retirement-planning tool. A Roth 401k allows you to make after-tax contributions to your retirement account directly from your paycheck, defer taxes on dividends and gains while that money grows, and then take qualifying retirement distributions completely tax-free.
In 2014, you can contribute as much as $17,500 (or $23,000 if you're aged 50 or older) to your Roth 401k if you have one available to you at work. If you have one, the ability to let that much money compound for decades and eventually get your hands on it tax-free makes the Roth 401k an appealing tool to use. While a Roth 401k makes sense for many people who are eligible for it, there are a few cases where you may be better served by alternative investing vehicles -- like a traditional 401k.
When a Roth 401k may not be the optimal choice
There are two key reasons why you might consider an alternative to the "tax-free withdrawal" carrot that a Roth 401k offers: tax rates and total invested capital.
From a tax rate perspective, if you expect your rate to be substantially lower in retirement than it is when you're working, you might be better off taking a tax deduction up front with the traditional 401k. The money still grows tax-deferred, and because of the tax deduction, you keep more in your pocket today for the same initial investment.
There's even a "golden window" between when you retire and age 70-1/2 when you can take money from your traditional 401k plan without penalty and you're not forced to take mandatory distributions. In that window, you may be able to:
- Pull money from your traditional 401k to cover your basic living expenses;
- Convert part of the remaining balance from your traditional 401k (where your tax was deferred) to a Roth IRA (where the money can continue to grow potentially tax-free); and
- Still be in a lower tax bracket than you were when you deferred the taxes in the first place
From a total invested capital perspective, you may want to consider a traditional 401k if you can't max out your retirement plan contributions. If you can max out your contribution, it is true that $17,500 invested in a Roth 401k is worth more to you than $17,500 invested in a traditional 401k thanks to the potential for tax-free withdrawals from the Roth 401k in retirement.
But consider this example: Say you can "only" scrounge up $10,000 per year after tax to invest in your Roth 401k and are in the 28% federal tax bracket and a 5% state tax bracket. For the same out-of-pocket cost, you can invest about $14,619 each year in your traditional 401k. That's 46% more cash, compounding tax-deferred on your behalf.
With that additional cash working tax-deferred on your behalf and some smart tax-planning around withdrawals, you could wind up better off than you would by investing less in a Roth 401k.
The Roth 401k is nevertheless an excellent retirement-planning tool
Despite those cases where you could potentially be better served by a traditional 401k, the Roth 401k has many qualities that make it a superb part of your retirement plan. It's hard to beat the possibility of tax-free withdrawals from an account that compounded tax-deferred for decades. If you have a Roth 401k available to you at work, it's certainly worth looking into.
If you're expecting to be in the same tax bracket or higher when you retire, or if you can max out your contribution to the plan, the Roth 401k is certainly a strong contender for your retirement nest egg.
Chuck Saletta has no position in any stocks mentioned. 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 may not 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.