The 401k legislation passed in 1978 and refers to the section of the Internal Revenue Code. These 3 numbers ending with the letter “K” have become synonymous with a company-sponsored retirement plan today. So much so, that most companies today do not offer another version of a retirement plan. So, understanding your options with your employer’s retirement plan is super important.
At first, 401K plans had just one flavor: Tax-Deferred. What does this mean? Essentially it means that with every paycheck, you can allocate a percentage to contribute to the 401k without paying income taxes on it. So that means that all the money you contribute to the 401k is not taxed while you are saving. No taxes are due on the growth of that money either. Taxes are paid when the money (and its growth) are withdrawn as ordinary income. For more information on Tax-deferred vs. tax-advantaged money, check out this post on my blog: Should I Convert to a Roth IRA?
In 2006, Congress allowed employers to offer a Roth version of the 401k as well as the original tax-deferred version. This Roth version was different by the way it is taxed. Every paycheck you still designate a percentage of your paycheck to the Roth 401k, but it is taxed as ordinary income upfront. After taxes are taken out and the money is in the Roth 401k account, it will never be taxed again, including the investment growth (with few exceptions).
While it is widely accepted that you should participate in your company’s 401k retirement plan (especially if your company offers to add to your contribution), deciding which 401k flavor to contribute to is not as straightforward.
There are several topics to consider when deciding between these two paths. Here are a few:
Pick a tax-deferred 401k if:
– Want to minimize taxes today versus in the future
– Likely to donate to charities after you turn 72 (which you can do without paying taxes)
Pick a Roth 401k if:
– If you believe tax rates in the future will be higher vs today
– If you will be in a higher tax bracket in the future
– Want to avoid Required Minimum Distributions (RMD’s) and the associated taxes
– Want your heirs to inherit money tax-free
Remember that you can always switch (or contribute to both) mid-way or towards the end of your career. For example, if your tax-deferred 401K balance has grown to the point you are concerned about taxes due to RMD’s, you can always switch your future savings to a ROTH 401K. Once you commit to a path, you can change your strategy based on your current savings and other life situations.