It is never too early to start squirreling money away for retirement, though future savings often takes a backseat to immediate wants and needs. Both traditional and Roth 401(k) plans avert the tendency of present desires trumping long-term benefits, by creating a mechanism to promote regular contributions of earnings into a retirement account.
While both plans share significant features, they also have one critical difference: the time when they are taxed. Unsure about which type of plan to choose? Read on to learn about the unique benefits offered through each option.
What is a 401(k)?
A 401(k) is an employer-offered defined contribution plan that affords employees the ability to make regular contributions to their retirement accounts. Aside from these regular contributions, the monies will be invested, usually in an assortment of mutual funds, continuing to grow over the years until they are needed during retirement.
Named after the section of the tax code which enabled the creation of this mechanism, 401(k) plans contain a number of unique features that are aimed at encouraging individuals to put money away for retirement.
The monetary advantages are two-fold: employer-matching and taxation benefits.
Many employers contribute to their employees’ savings accounts, offering to match their contributions either fully or in part. Companies who offer a 100% matching option are essentially giving participating employees the ability to double their contributions to their retirement account, though smaller contributions also add up.
Because stability is key for companies, they want to incentivize their workers to remain employed. While all contributions that employees make are theirs from the start, many employers require a certain period of time before the funds they pay-out fully belong to the employee. Known as “vesting,” this can be a range of time periods, but never longer than 6 years before the entire employer contribution is completely yours.
Taxation benefits are also an inherent part of the 401(k) package, though these are different for traditional 401(k) and Roth 401(k) plans. (This distinction is explored in more detail in the following section.)
Aside from the employer matches and tax breaks, there is another intangible benefit that comes along with participating in a 401(k) plan: automatic contributions. The automation of savings makes this line item a pre-defined part of your monthly budget.
Because the contribution is directly deducted from your paycheck, it goes straight into your retirement fund. It does not stop along the way in your checking account, removing the temptation to spend it.
You can use TipRanks’ 401(k) calculator to understand how your account will grow over time based on your contributions and employer matches. Note that this calculation does not take into account whether you are using a Traditional or Roth 401(k) plan.
What are the Differences Between a Traditional 401(k) and a Roth 401(k)?
The major difference between traditional 401(k) plans and Roth 401(k) plans is the timing of when the tax collector comes to take its due.
First, let us look into how traditional 401(k) plans are taxed.
Contributions to traditional 401(k) plans are exempt from taxation at the time when the monies are transferred. In other words, if you make $75,000 and contribute $5,000, you will only pay income tax on the $70,000 that is left.
This money will remain untaxed as your portfolio grows. There will be no capital gains taxes, even on dividend payments, as long as the money stays in your account.
However, the tax collector will eventually arrive at your doorstep. When you take money out of your traditional 401(k), you will need to pay ordinary income tax on the funds you withdraw. (The withdrawal of funds from your retirement account is also known as a distribution.) The money that remains in your account will remain untaxed until it is distributed.
For a Roth 401(k), the tax situation is reversed.
Contributions to your Roth 401(k) plan are made after income taxes have been paid. In the above example, your contribution to your Roth 401(k) plan will not decrease your tax burden for that year.
However, while there is no immediate tax break, you will not pay additional taxes on this money later on down the road. In other words, the monies you earn from your Roth 401(k) will not be taxed when you begin receiving your distributions. This encompasses money you have earned via capital appreciation, dividend payments, and the overall growth in your portfolio. (You will pay ordinary income taxes on monies that your employer has contributed, however.)
This tax benefit applies only if you do not withdraw monies before you turn 59.5 and have owned the account for at least 5 years, though there are exemptions for people suffering from a disability.
How to Decide Between a Traditional 401(k) and a Roth 401(k) Plan
If your employer offers both a traditional 401(k) and a Roth 401(k) plan, there are essentially two issues to take into consideration when deciding which option to take.
The first issue is your tax obligations. For individuals who believe that they will be in a higher tax bracket later on in retirement–due to other sources of income in these later years–a Roth 401(k) could make more sense. Remember, you will have already paid taxes on this income, so the distributions from these funds will not count towards your tax obligations.
However, if you believe that your tax bracket will likely decrease during your golden years, then a Traditional 401(k) plan could be a better fit for you. Your tax obligations will be higher now, so it might be worthwhile to defer them to a later date.
The other issue is your current financial situation, and what your monthly budget looks like at present.
Using a Traditional 401(k) will increase your bank account in the here and now, as you save on the monies you owe in taxes every year. If you are servicing debt at high interest rates–especially credit card debts, which often compound daily–paying off this money might take precedence over saving for retirement.
If you are unsure, it is always a good idea to consult with a financial professional, who can help you determine the right financial path for you.
Conclusion: Saving Money for Retirement
Starting to save money for retirement should be an important goal for everyone, and the earlier you start the better.
Both types of 401(k) plans can help you progress down the road towards financial security upon retirement, by offering tax benefits, company matching funds (in many cases), and an automatic way to put money aside for later.
401(k) plans provide a great way to make sure that your money will be working for you, even after your own working days have ended.
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