This article is about two types of 401k plan that are offered by employers. It is obviously aimed at people who are now gainfully employed. Because it is never too early to start planning for your retirement, you should read this even if you’re just beginning your working career.
The two types of 401k are called “Traditional” and “Roth”. These plans have many similarities. They are both a type of retirement fund, but they are not pensions. You own them and you manage them.
No matter what type of 401k you have, money is automatically deducted from your paycheck. By participating in a 401k you are effectively giving your employer permission to help you save money. In many cases, your employer will match some part of your contribution. This means that no matter how little or how much you put in, your employer must also put something in. You will need to check your employer’s policy on this. How much you contribute might depend on how much ‘they’ put in as well. In cases where the amount matched is high – well, this is as close to it gets to ‘getting something for nothing’. Finally both types of IRA allow you to withdraw your savings when you reach age 59½.
Although you can actually participate in both a traditional and a Roth 401K, there is a limit of $16,500 (2010 and 2011), total, that you can stash away. Again, keep in mind how much your employer matches each type of fund before deciding how much to put in either one or both.
There are some differences between a traditional and a Roth IRA that you should be aware of. The first of these refers to when the funds are withdrawn from your earnings. Funds for a traditional 401k are taken out of your pre-tax earnings. This means that your taxable income is reduced by the amount you contribute. Funds for a Roth 401k are taken from after-tax earnings – your taxable income is not reduced. Knowing what your current tax rate is, considering how far you are from becoming 59½, and having an idea of how many more years you want to work can be determining factors in which type of 401k to choose.
The second difference between the two types of 401k is easy to understand. Quite simply, funds withdrawn from traditional 401k (after age 59½) are taxed. Those that are withdrawn from a Roth 401k (also after age 59½) are not.
The third major difference between the two types of 401k become clear when you leave your company or stop working, but are not yet ready to withdraw your ‘savings’. A traditional 401k can be rolled over into another traditional 401k, tax free. However, it cannot be rolled over into a Roth IRA without being taxed. A Roth IRA can be carried into a new Roth IRA with no tax assessment.
A little final general advice will help you choose which 401k plan will be best for you. If you plan to be in the same or higher tax bracket at age 59½ than you are now, then a Roth 401k may be the best plan for you. Otherwise, the traditional kind may be more suitable. No matter which type of 401K you participate in, you will be in a win-win position.