A 401k is a type of self-directed employer sponsored retirement account but it is not a pension.  While these types of retirement accounts are a service provided by your work, they are owned and managed by you. They allow employees to have savings invested while deferring income taxes (non Roth). Lets take a quick look at these 401k’s and how they work:

Traditional 401k

• Your employer will offer pre-tax contributions through payroll deductions
• Your taxable income is reduced by the amount you contribute (Maximum Contribution Amount 2010 & 2011 – $16,500)
• Not required but sometimes an employer will contribute to the plan (i.e. 50 cents for every dollar up to 6% of your pay)
• At age 59½ you can withdraw from the plan with no penalties but you will be taxed on the amount withdrawn
• Can be rolled over into an IRA tax free if you leave job
• If rolled over into a Roth IRA it will be taxed

Roth 401k

• Your employer will offer you to make after-tax contributions through payroll deductions (Maximum Contribution Amount 2010 & 2011 – $16,500)
• Doesn’t reduce taxable income
• Not required but sometimes an employer will contribute to the plan the same way as a Traditional 401k
• At age 59½ you can withdraw from the plan without penalties and tax-free
• Can be directly rolled over into a designated Roth IRA account without penalties

So what if my employer offers both Traditional and Roth IRA, how do I know which one to choose?

This all depends on where you plan to be financially when you retire.  If you plan to be in a low tax bracket when you retire then the pre-tax contributions from the Traditional 401k will be better for you.

Keep in mind that by the time you retire you may have fewer deductions, less dependents living with you, the house is possibly paid off, etc.  This would give you less to write off on your taxes therefore putting you in a higher tax bracket and keeping less of your money.

If you plan to be in the same or higher tax bracket then a Roth 401k is the better plan for you.  This way you won’t get killed in taxes because you already paid them when you were in a lower tax bracket.

Can I contribute to both Traditional and Roth 401k?

If you are offered to do both then you can take advantage of that as well if it makes sense to your financial needs.  But remember that if you have multiple 401k plans you can only contribute a maximum of $16,500 in total between the two retirement plans.

IMPORTANT: You don’t want to turn down free money so be sure to check with your employer to find out if and what the company will contribute.  If they only contribute to one of the 401k retirement plans be sure to take advantage of that plan.

What questions do you have regarding retirement plans?

You Might Also Like:

• Can I Contribute To A 401K And A Roth IRA
• Are Withdrawals from a ROTH IRA Taxable?
• What You Need To Know About Roth IRA’s
• Retirement Strategy For The Millennial Generation
• What Is A Traditional IRA