What’s the Difference Between a 401(k) and a Roth 401(k)?
Hypothetical: Let’s say you begin a new job (Congratulations!) and it’s your first day in the workplace. After the office tour, you’re probably going through the process of enrolling for employee benefits with the Human Resources representative. Scanning the retirement benefits form, you suddenly stop when you make it to the 401(k) contribution section, confused by your two options: Traditional 401(k) and Roth 401(k). What’s the difference? What to do next?
Traditional 401(k) contributions have been around since the 401(k) plan was created: you the employee specify a fixed percentage (%) or dollar amount ($) that is deducted from your paycheck and deposited to a retirement account created for you by your employer. Then the funds are invested in stocks and bonds for future growth to fund your retirement. Traditional 401(k) contributions are made on a pre-tax basis, which simply means that income taxes are not withheld on those amounts set aside for retirement. Instead, you pay income taxes when you take a distribution payment from the Traditional 401(k) when you are retired.
Roth 401(k) contributions are a relatively new concept – you the employee still specify a fixed percentage (%) or dollar amount ($) that is deducted from your paycheck and deposited to your employer-sponsored retirement account, but the key difference is that Roth 401(k) contributions are made on an after-tax basis. This means that taxes are withheld on the amounts you set aside for retirement, and the net amount after withholding is invested for future growth. When it comes time to take a distribution payment from the Roth 401(k) when you are retired, no income tax is due – it was already paid when you set the money aside earlier.
Choosing the Best Option for You
Now that you understand the difference, which one should you choose? It depends on income tax rates – if one expects income tax rates to increase in the future, a Roth 401(k) contribution makes sense (better to pay the lower income tax rate today and avoid the higher income tax rate in the future when you are retired and begin taking distributions). On the flip side, if one expects income tax rates to decrease in the future, a Traditional 401(k) contribution is preferable (better to avoid paying today’s high income tax rates and instead pay a lower rate in the future when you begin taking distributions in retirement).
Without a crystal ball, it is difficult to know what will happen with income tax policy – that’s up to Congress. You might consider hedging your bets and making both Traditional 401(k) and Roth 401(k) contributions. Let’s say you’ve decided to contribute 10% of your wages to the 401(k) – you could split it 5% Traditional 401(k) and 5% Roth 401(k) if the plan allows. Be sure to consult with your accountant/tax preparer, a wealth advisor and your Human Resources representative for the details.
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