With more employers doing away with pension plans, the 401(k) plan has become a vital retirement planning tool. But how do you choose between a Roth 401(k) and a traditional 401(k) plan if your employer offers you both, or if you’re simply trying to decide on your own if one is better than the other? Here’s what you need to know.
The main difference between the two retirement savings accounts are the way they are taxed. With a traditional 401(k) plan, the money you put into your account (your contributions), are made with pre-taxed dollars. Simply put, your employer takes money out of your paycheck before taxes, allowing you to reduce your taxable income and lower your taxes in the year that you contribute. Your contributions and any earnings in your account won’t be taxed until you begin to withdraw your money (typically in retirement), and you’ll pay taxes on both based on the then-current rate.
Traditional 401(k) = income taxes paid on withdrawals from your account
With a Roth 401(k) plan, the contributions you make to your account are made after your employer withholds taxes. Because you have already paid taxes on your contributions, you won’t owe taxes on contributions or earnings when it comes time to withdraw your money – again, typically in retirement. However, it’s important to note that if your employer offers a company match on your Roth 401(k), that money is made with pre-taxed dollars. This means that the money your employer contributes, as well as any associated earnings you may accumulate, will be subject to regular income tax when it’s withdrawn. Furthermore, the IRS has established criteria for what constitutes a "qualified withdrawal," which are tax-free disbursements.Roth 401(k) = income taxes on paid on contributions to your account
Whichever 401(k) plan you choose, it’s always a good idea to have a mix of retirement accounts so that your money is tax-diversified. Simply put, this means having both tax-deferred accounts that you won’t have to pay taxes on until you retire, as well as accounts that have already settled up their tax bill.
For more information on 401(k) plans, as well as other ways to save for retirement, visit Protective’s Learning Center.
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