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Understanding the Differences Between a Traditional 401K vs Roth 401K

Personal Finance

Understanding the Differences Between a Traditional 401K vs Roth 401K

It’s becoming more common to see employers who offer 401(k) plans to their employees, as well as Roth 401(k) plans. But what is a Roth 401(k)? People have usually heard of the difference between a traditional and Roth IRA (Individual Retirement Account) and the same concept applies to 401(k)s.

What’s the Difference?

There’s really only one big difference between traditional and Roth 401(k)s, and it has to do with when you want to pay taxes, and whether or not you want deductions.

With a traditional 401(k) you make contributions with pre-tax money, which affects your taxable income later on when April rolls around. However, when you’re retired and use this account as your income, you’ll be paying taxes on it annually, at whatever is the current tax rate at that time, since it will be a part of your income for the year.

The Roth 401(k) is contributed to your account with post-tax money, meaning you already paid taxes on it, so you won’t have to again, since you already initially claimed it as income. When you retire and choose to live off the money, you can withdraw it without having to pay taxes on it.

An easier way to keep these two straight is to swap the word “traditional” for “(tax) deductible” and the word “Roth” for “(tax) exempt.”

Which Should You Choose?

This will depend on your own personal financial situation. In an ideal world, you have both of these accounts, and you split your employer match 50/50 between the two. Choosing to contribute like this not only saves you money in taxes now, but it saves you in the future as well. You’ve hedged your bets on both sides.

If you’re starting off in your career and can’t afford two accounts but want to choose one, the traditional option might be best for you. This way, you’ll save on taxes, which is typically important when you’re not making the big bucks yet.

However, if you’ve been saving for years, or have a large enough income to not necessarily need the tax break, then a Roth 401(k) would be a good choice for you. You’ll have the peace of mind knowing what’s in your account is yours to keep in your golden years.

In any case, make sure to contribute as much as possible, up to your employer’s match. This ensures you fill your account with as much extra money as possible.

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