Wednesday, January 30, 2008

Which one: Roth 401k vs. Traditional 401k? The truth is in your pay stub.

The first point to understand is, "What's the difference?"

A Traditional 401k is a tax-deferred retirement plan. Contributions are made up to a specified limit with the contribution being tax deductible. Money invested and earned in a Traditional 401k are subject to income taxes at the time of withdrawal.

Roth 401k contributions can be made up to a specified limit on a non-deductible basis. This means a contribution can be made to a Roth account but no deduction can be taken from income tax. Withdrawals at the time of retirement are tax free within certain limitations.

Many companies are starting to offer both a Roth and Traditional 401k. So why should you choose one over the other? Well, first I'll say discuss this issue with your financial planner. However, if you're looking for a basic explanation, here it is:

First Point-to-Ponder
Traditional 401k's allot you a tax shelter at the end of the year. Roth 401k's don't. Therefore, if you have enough money to need a shelter, a Traditional 401k is a good way to go. If you don't make enough to reap the benefits of a tax shelter or an additional deduction, then I'd allow my money to grow tax-free in a Roth until the time comes that getting that deduction outweighs the tax-free growth rate.

Another point to remember is tax brackets. Traditional 401k's allow you a tax deduction during your earning years and then you pay tax on that money when withdrawn. The deduction during your earning years is important since your tax bracket is projected to be higher during this time (meaning more tax paid), making the deduction worthwhile financially. When you retire your earnings naturally go down so that you're in a lesser tax bracket (meaning less tax paid). This means that although at retirement you'll pay tax, you're likely to pay less tax during this time than had you paid tax on those monies when earned. Therefore, Traditional 401ks can give you money back at the end of the tax year during your earning years and allow you to pay less tax on your money during your disbursement years, which could equal more disposable income for your overall.

Second Point-to-Ponder
Use of a Traditional 401k assumes that at retirement you will be earning less than when you were working. If you plan a lofty, extravagant retirement, the benefits of a Traditional 401k may not apply to you. In this case, a Roth 401k may seem smarter.

Third Point-to-Ponder
The first two points assume a static tax system with no change. Now both you and I know this is untrue, but we don't know how the tax system will change. If you would like to work with the tax brackets of today and not bet on tomorrow, a Roth is for you. If you're not too worried about tax law changes or are the gambling type, a Traditional 401k would be a better option.

In Conclusion
So, you've got some hefty decisions to make. In all, if I were young and just starting out I'd go with a Roth, keeping an eye on my paycheck. Once those raises and bonuses come in, it may be time to transition into a Traditional 401k. Oh, and a word of caution... once invested, money in a Roth cannot be rolled into a Traditional. So know that when deciding too.

Additional Resources:

Roth & Traditional 401k's per Wikipedia

Leave That 401k Alone, Or Else!

Traditional vs. Roth IRA

Roth IRA- Distributions Taxable or Not?

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