Employer-Sponsored Retirement Plans: How Do Traditional 401(k) and Roth 401(k) Work?

You can find different types of employer-sponsored retirement plans offered by companies. Usually, wherever you work, you can invest in an Individual Retirement Account (IRA) or an employer-sponsored retirement plan. However, each account has specific rules regarding contribution limits, taxes, and withdrawals. Nowadays, more and more young employees are offered employer-sponsored retirement plans such as 401(k) plans. In this article, we will learn about the most common retirement plan in the United States, which is 401 (k).

How does the 401 (k) plan work?

A 401(k) plan is a qualified plan which is eligible for tax benefits. This plan allows employees to contribute a portion of their salary to a retirement account in a tax-advantaged way. According to the 401(k) Plan, you can get tax benefits in 2 different ways, namely  401(k)s—traditional and Roth. Moreover, 401(k) Plans allow employers to match your contributions and help to grow your retirement funds faster.

Types of 401(k) Plan

Two types of 401(k) accounts (traditional 401(k)s and Roth 401(k)s) are offered by employers. Both have similar requirements in many respects, but each is taxed in different ways. You may have either type of account or both types.

Differences between Traditional 401(k) and Roth 401(k)

The main difference is paying the taxes now or later. Generally, if you want your account to be funded with pre-tax (tax-deferred basis) dollars, you may opt for a traditional 401(k). Of course, you can take advantage of the immediate tax break. You will have to pay the tax when you withdraw your funds. On the other hand, if you want your account to be funded with after-tax dollars, you might opt for the Roth. For instance, a Roth is a wise choice for new employees whose salary is low at the beginning of their career but potentially higher later. In other words, employee contributions to a traditional 401(k) reduce their income taxes for the year they are made, but withdrawals are taxed. In Roth (401)k, employees contribute with post-tax income, but they can withdraw their money tax-free.

Note: If you have been holding your retirement account for at least five years, your withdrawals of both contributions and earnings are tax-free at age 59½.

If you want and your employer offers both options, it is better to split the contributions into traditional 401 (k) and Roth 401 (k). However, your overall contribution to the two types of accounts should not be over the limit for one account. In 2020 and 2021, one account can have $19,500 if you are under age 50.

Depending on what happens with tax rates in the future, either of the plans can make you more profit. So, keep both accounts, putting some of your money into each to be on the safe side. 

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