5 Reasons to Save for Retirement in a Roth 401(k)

Prepaying taxes on part of your savings gives you tax diversification and flexibility in retirement.

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When you contribute to a Roth IRA you typically don’t have to worry about paying taxes on that money or its investment gains ever again. And employers are increasingly adding a Roth option to their 401(k) plans. Aon surveyed 400 employers covering 10 million employees in 2013 and found that half now offer a Roth 401(k) plan. Here are some of the benefits of saving for retirement in a Roth account:

Having a tax-free account in addition to your pre-tax savings gives you more options to reduce taxes in retirement. Tax complications don’t end when you leave the workforce. In fact, your taxes in retirement can actually be more complicated than in the years when you were working. For the most part, you’ll want to withdraw money you have in taxable and Roth accounts first and delay paying taxes on your savings in traditional retirement accounts as long as possible. But it’s also possible that you could pay significantly higher taxes if you delay too long and your traditional retirement account gets big enough for required minimum distributions to force you into a higher tax bracket. With money in different pots, you'll have a chance to run different scenarios and maximize your after-tax retirement income.

You can effectively contribute more of your wealth to tax-sheltered accounts every year. A dollar in a Roth is worth more than a dollar in a pre-tax account because Uncle Sam will eventually take a share of money in a traditional 401(k). While the annual limits on contributions to Roth and regular 401(k)s are the same, those who contribute the maximum to a Roth will effectively protect more of their wealth from future taxes than those who deposit the same amount in a traditional 401(k). Having $17,500 in a Roth account that won’t be taxed again means that entire account balance belongs to you, while $17,500 in a regular 401(k) that will be taxed at the 15 percent rate is ultimately worth only $14,875.

If tax rates increase, money in a Roth IRA will be even more valuable than the same amount in a pre-tax account. Tax rates are currently much lower than they have been throughout much of our country’s history. If taxes are increased, your Roth account will become even more valuable because you already paid the taxes on your contributions at the lower rate.

You will feel poorer. Diligent savers might look at the total value of their portfolio and dream about the lifestyle the sum can afford. However, when you pay taxes first, your final account balance may end up being a bit lower. However, the smaller account balance might also motivate you to kick your savings rate into high gear. Getting ahead financially is often a game of psychology. If a smaller after-tax account keeps you from wasting more of your hard-earned cash, you will ultimately be better off in retirement.

You might be able to tap your Roth contributions penalty-free before you reach 59 1/2. There are ways to tap money in pre-tax accounts too, but there’s often a 10 percent early withdrawal penalty. With a Roth, contributions can be withdrawn from the account after five years, assuming the employer allows in-service withdrawals. And money rolled over from a Roth 401(k) to a Roth IRA can be taken out penalty-free five years after the rollover date, which can be very handy if you run into an emergency.

Many people are better off deferring taxes on their retirement savings for as long as possible because very few people will have an equal or higher tax rate in retirement than they do while working. However, doing at least part of your retirement savings in a Roth 401(k) will give you options in retirement. Some employers will allow you to save in both a traditional and Roth 401(k) at the same time, which helps you to hedge your bets about future tax rates.