When you start working at a new company, you typically have a few money decisions to make during those first days on the job.
One of those decisions is often whether you want to sign up for a Roth 401(k) or a traditional 401(k) plan. While you may understand having a retirement plan is important, how do you know which plan is right for you?
To help you understand your options, here are the answers to a few common retirement plan questions.
What is a traditional 401(k) plan?
If you sign up for a traditional 401(k) plan, your employer deducts your contributions from your paycheck. As an added perk, your taxable income is reduced by the amount of your contributions.
However, you still pay Social Security and Medicare tax, also known as FICA, on your full pay.
When you receive Form W-2 next January, the taxable wages listed are already reduced by your deductible contributions.
When you retire, you then pay tax on any withdrawals from the traditional 401(k) plan. Tweet this
What’s a Roth 401(k) plan?
If you choose a Roth 401(k) plan, the company still deducts your contributions from your paycheck. However, your contributions do not reduce your taxable income. In other words, you’re paying your taxes on Roth 401(k) contributions upfront.
The good news is when you retire, you can generally take withdrawals from your Roth 401(k) plan tax-free.
Can I choose both?
Contributing to both Roth and traditional retirement plans is not only possible, but it may be a good idea.
Let’s say you retire at age 66, and for the first few years, you have a comparatively low retirement income. This would be an ideal time to take withdrawals from a traditional 401(k) plan while you’re in a lower tax bracket – the lower the tax rate, the more money deposited into your bank account.
On the flip side, you may have a year when you sell an investment property, work as a consultant, or have other taxable income that pushes you into a higher tax bracket.
In this case, if you still want to take withdrawals from your retirement plans, this would be a great year to take tax-free withdrawals from a Roth 401(k) plan as you will already have paid the tax on the money you receive.
There may be years you may wish to take withdrawals from both your traditional 401(k) and your Roth 401(k) accounts. Having both types of plans gives you greater financial flexibility than having one plan alone.
Can I convert my traditional 401(k) to a Roth 401(k)?
If your plan allows it, you may be able to convert some or all of your current traditional plan to a Roth 401(k) plan.
There’s a catch, however. You have to pay tax upfront on any pretax contributions and earnings you convert.
So, which plan is best?
If you expect to have substantial income in retirement, it may be best for you to use a Roth 401(k). But, if you expect to be in a lower tax bracket after you retire, you may prefer a traditional 401(k) plan.
However, for practical purposes, most of us aren’t sure how much income we will have when we retire – especially if retirement is years or decades away.
If you can commit to contributing to a Roth plan – great. If having a lower tax bill is more beneficial to your financial stability, go with the traditional 401(k) plan. The important thing is to choose a plan and use it.