Many businesses undertake some form of planning to help both owners and employees save for retirement. The most popular vehicle for this has historically been the pension plan. This was, of course, replaced by the hyper popular 401K plan. The traditional 401k plan has been such a success because it allows a person to sock away pre-tax earnings. These earning can then accumulate tax free. The only downside has been the earnings are taxed when they start being distributed one the retirement age is met.
The Roth 401k is similar to the traditional 401k plan in much the same way a Roth IRA is similar to a traditional IRA. The primary difference has to do with tax treatment of contributions and distributions. With a traditional 401k plan, contributions are made with pre-tax dollars, but distributions are taxed as income. The Roth 401k, on the other hand, is funded with after tax dollars, but the eventual distributions are made tax free.
So, which is the better choice? Well, the first issue is a practical one. The Roth 401k is a fairly new beast, only coming into existence in 2006. As a result, the company you work for may not know about it, much less offer it as an option. If it does not, you might want to make note of the possibility and politely harass the HR department until they get on top of the subject!
Assuming you have the option of a Roth 401k, should you invest in it over a traditional 401k? As with many retirement question, the answer depends on your particular situation. If you are relatively young, the Roth 401k is attractive since your contributions will have a lot of time to grow. This makes the ultimate distribution bigger and the tax free aspect more appealing. As a younger investor, you probably also in a lower tax bracket, which makes paying taxes on the contributions now more attractive than when you retire and are probably going to be in a higher tax bracket.
So, is there a clear cut area where you should avoid contributing to a Roth 401k? Yes. If you are closing in on retirement, you need to watch out for a trap. If you only have five years till you retire, avoid the Roth 401k like the plague. Why? Any distributions made for a plan you participate in for less than five years are taxed. In short, you would get taxed when contributing and receiving the money!
The Roth 401k is so new that the exact situations where it makes the most sense to use are still being investigated. That being said, this is a retirement vehicle you should definitely keep an eye on.
Learn more about Roth retirement vehicles by speaking with one of the financial consultants at UFCAmerica.com
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