Many American workers have the benefit of a 401(k) plan at their place of employment. First introduced by Congress in 1978, these plans enable retirement savings to grow tax free, and they’ve become very popular. Employees are able to contribute a certain amount of their earnings each year in the form of “elective deferrals,” and contributions are pretax.
Let’s say an employee makes $100,000 in wages in 2012. Let’s say, further, that he makes the maximum possible contribution to his 401(k) account for that year — $17,000 in 2012. That amount is immediately deducted from the employee’s taxable income, so he is taxed on only $83,000 of income (barring additional deductions and adjustments). That’s quite tax benefit. And if he’s fifty years of age or older, the employee can make an additional “catch-up” contribution of $5,500 (in 2012), for a total possible contribution of $22,500, all before taxes.
Funds invested in a 401(k) then grow tax free as the employee continues to make contributions. The account is only taxed when the employee begins to make withdrawals in retirement; withdrawals are taxed as regular income.
In 2006, Congress enabled a new form of 401(k): the Roth 401(k). This retirement savings vehicle is a blend of the traditional 401(k) and the Roth Individual Retirement Account (Roth IRA). The same annual contributions limits apply to a Roth 401(k): $17,000, with a $5,500 additional catch-up contribution for those fifty and older (in 2012). However, contributions are NOT pretax — they are fully taxable. Taking the example above, if an employee making $100,000 in 2012 were to contribute $17,000 to his Roth 401(k) that year, he would still pay tax on his full earnings, $100,000.
Money accumulated in a Roth 401(k) grows tax free to retirement, and the benefit kicks in at that time. As with a Roth IRA, all withdrawals from a Roth 401(k) are entirely tax free. Certain rules apply: one can’t begin to withdraw from a Roth 401(k) before the age of 59½, and one must have held that account for at least five years before making the first withdrawal. (Certain exceptions apply.)
Many employers offer matching contributions to employee 401(k) accounts; such matching contributions cannot be invested in a Roth 401(k). If an employee wishes to open a Roth and continue receiving matching contributions, he must then have two 401(k) accounts: one pretax (for the matching contributions), and one after tax (for his own contributions). Eventual withdrawals from the former will then be taxable as regular income; withdrawals from the latter will be tax free.
Likewise, any employee can open two 401(k)s at his place of employment, one regular and one Roth, with the same withdrawal rules as above, provided TOTAL contributions to both accounts don’t exceed the annual limit. This way, an employee can mix the benefits of tax-free contributions with the benefits of eventual tax-free withdrawals.
You’ll need to do the math to determine which flavor of 401(k) is best for you, or whether some combination might work. Roth IRAs are almost always a better choice than regular IRAs; with 401(k)s, however, the choice isn’t always as clear. A $20,000+ tax break year in and year out can be enormously beneficial, and if one anticipates that one will be in a lower tax bracket in retirement — meaning that eventual withdrawals will still be taxed, but not as much — then a regular 401(k) is probably a better choice. However, if you expect to be in a high tax bracket in retirement and expect to amass a substantial 401(k), then the tax-free withdrawals will be of tremendous benefit at that time.
One or the other should work for you. And if you don’t have a 401(k) at all and your employer offers one, then visit your personnel office as soon as possible to open one.
IRA Calculator will help you determine:
IRA calculator helps you decide whether a Traditional or Roth IRA is best suited for your needs.
How much you need to withdraw each month once you retire to live comfortably
How much you need to contribute each month to maximize employer contribution for monthly retirement withdrawal goal
How you can forecast for your contributions’ affect on your retirement savings can be done through our online 401-K calculator.