That’s what makes it so important to understand the ins and outs of these savings tools, including knowing the difference between traditional and Roth 401(k) plans. Here’s a look at the features that make each one unique, and how you might be able to take advantage of both.
Traditional 401(k) basics
With traditional 401(k) plans, employees make contributions before their income is taxed. It’s a win-win situation: As well as preparing you for retirement, this setup also reduces your taxable income.
The cash in your account is invested in mutual funds, stocks or bonds, and it’s up to you to decide how you want to allocate your assets. The money in these investment vehicles grows tax deferred until you withdraw it.
At that point, the money you withdraw will be treated as regular income and taxed at your normal rate. Remember, though, that requesting distributions before you’re 59½ will also trigger a 10% penalty.
Roth 401(k) plans
Roth 401(k) plans function much like traditional plans. Money is also placed in mutual funds, stocks or bonds, and the same contribution limits apply. In 2015, the contribution limit for both traditional and Roth 401(k) plans is $18,000, or $24,000 for people over the age of 50.
Roth 401(k) accounts differ in one major way: You make contributions after your income is taxed. That means that you won’t be reducing your taxable income when contributing to a Roth plan. But don’t fret — there’s good news too: If you’ve been enrolled in a plan for at least five years, any withdrawals that you make after age 59½ won’t be taxed. And although high earners typically don’t have access to Roth individual retirement accounts (IRAs), anyone can contribute to a Roth 401(k) plan.
Both traditional and Roth 401(k) plans allow employers to match all or part of your contributions. In the case of a Roth 401(k), though, the matching contributions must be put in a pretax account, like a traditional 401(k), rather than going into your Roth 401(k) itself.
You may want to consider opening a Roth 401(k) plan if you think you’ll end up in a higher tax bracket by the time you retire, since your withdrawals won’t be taxed. It also would be a good idea to mull this over if you’re young, since your earnings still have dozens of years to continue to grow tax-free.
Depending on your employer’s policies, you may be able to use both types of 401(k) plans. If so, you’ll benefit from a reduced taxed bill now and won’t have to pay taxes on some of your money come retirement.
It pays to educate yourself about your employer’s various retirement plan offerings. Otherwise, you could miss out on the potentially valuable benefits of a Roth 401(k) account. For additional information, check out the IRS’ website, which can help break down the different types of retirement accounts even further.
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