October 3, 2017. By Lori Patterson:
When people hear these words, anxiety can set in quickly. Unless you are employed in an industry where you work directly with these types of plans and have developed an understanding of them, it’s likely that you too have reservations about choosing one of these plans. The first step to understanding and choosing the right plan for you begins with understanding the plans and the differences between them.
Opting to invest in a traditional 401(k) and/or a Roth 401(k), over time, has proven to be an effective way to save for retirement. One or both of these plans can be beneficial depending on your individual situation and retirement goals. Many employers offer both types of plans which allow employees to better customize their retirement savings plans.
It may also be helpful to define the basic plan. A 401(k) plan, in general, refers to a retirement plan offered by an employer which allows employees to save for retirement by contributing a percentage or portion of their earnings to the plan and then choosing investment options within the plan. Within the 401(k) plan, the following options can be considered.
A traditional 401(k) plan offers the benefit of pre-tax contributions which reduces the impact of taxes on your net earnings, allowing the opportunity for you to save more for retirement. These funds and the earnings/growth will be taxed when they are withdrawn from the plan, ideally at retirement, when your taxable income will likely be lower. Often times, those in a higher tax bracket will choose this option since they expect to have a decreased income and therefore a reduced tax liability when retired.
A Roth 401(k) plan may offer greater benefits at retirement age. Roth contributions are not considered pre-tax or deductible; however, when the funds are withdrawn at retirement, the contributions and the earnings/growth can be withdrawn tax-free. Often times, people who choose this option are earning lower than or equal to the amount they expect to be earning in the future. Lastly, a Roth 401(k) plan can later be rolled into a Roth IRA, in which case the owner would not be required to take distributions at age 70½ as is the traditional IRA owner, allowing the funds to continue to grow tax-free.
There are some cases in which it may be appropriate to contribute to both types of retirement plans and this can be done within the same 401(k) plan if your employer offers a Roth 401(k) option. If so, your plan’s sponsor or administrator is required to track the contributions that you make separately into each plan for future tax consideration. If you choose to contribute to both plans, the total annual contribution rules still apply.
Although it may seem overwhelming and confusing when trying to understand the differences in the types of retirement plans offered, it is worth the effort to make an educated decision and plan as early as possible for retirement in order to help reach your long term goals.
For additional information to help explain the differences between the two plans please visit: https://www.irs.gov/retirement-plans/roth-comparison-chart