As an employee of a company you may have access to a 401(k).
A 401(k) is an employer-sponsored (offered) retirement plan that allows you to
save money for retirement. Sometimes your employer may provide a match based on
a percentage of your contributions.
Your employer may give you the option of saving to a pre-tax
account or a Roth account. A pre-tax contribution means that your contributions
are made to your account before federal and state taxes are applied to your
paycheck. A Roth contribution means that taxes are taken first, then the
contribution goes to your account. This is also known as an after-tax
If you make pre-tax contributions, you avoid tax now, but
then are taxed when withdrawals are made in retirement. If you make Roth contributions
now, you’re taxed today, but withdrawals in retirement are tax-free.
It can make a lot of sense to contribute to your Roth 401(k)
for a few reasons.
- If you’re in a lower tax bracket now, you’ll pay
less tax on your contributions today, and avoid taxes in retirement when taxes
rate may be higher, or your income is higher and taxed at a higher rate. This
is especially true for young college grads in their first job.
- The bulk of your money in your account will
eventually be growth of your investments and reinvested dividends. With a Roth
account, this will be tax-free when withdrawn at retirement.
- Having tax-free income in retirement means that
your Social Security benefits may not be subject to taxation; since qualified
Roth distributions are not taxable income.
- Mentally, not having to pay any (or very little)
tax in retirement can be reassuring when it comes to planning for expenses,
distributions, and bequeathing.
- It may mean that since your Roth distributions
are not being taxed, any long-term capital gains may be subject to zero tax.
- You may not be able to make Roth IRA
contributions (your income may be too high). A Roth 401(k) doesn’t have income
Personally, I favor Roth contributions. I like the tax-free
benefit of qualified distributions in retirement. It should be noted however,
that any employer match to a Roth 401(k) will be made to a pre-tax account (as
the employer is allowed a tax deduction for the matching contribution). Your
employer match will not be Roth dollars.
This should not be a discouragement from saving to your Roth