Source: Flickr user taxcredits.net
While saving for retirement is hard, the government has taken steps to make it easier -- or, at least, a little cheaper.
Nearly 10 years ago, companies were granted the ability to offer a second type of 401(k) plan to their employees. Known as a Roth 401(k), it offers a number of pros and cons vis-a-vis the traditional 401(k) plans that you're probably more familiar with.
Which option is best for you? Read on to find out.
The basics
Roth 401(k) plans allow employees to set aside part of their paycheck for retirement while providing unique tax advantages that allow more of that money to remain in your wallet throughout retirement.
In short, contributions to a Roth 401(k) plan are made with after-tax money, and, given that employees pay the tax on those contributions upfront, distributions from a Roth 401(k) plan are typically tax free -- this is assuming that the plan is at least five years old and that the owner is at least 59.5 years old.
Contributions to a traditional 401(k), on the other hand, are made with pre-tax dollars. This lowers your tax bill now, but the downside is that, unlike a Roth 401(k), withdrawals are typically taxed as ordinary income. Thus, the greatest deciding factor between the two is whether you should pay taxes on the underlying income today or in retirement.
Regardless of which type of plan you choose, however, the contribution limits for 2015 are the same. Employees can contribute up to $18,000 in income to either plan ($24,000 if you're over age 50) this year.
The pros and cons
The pros and cons of a Roth 401(k) plan relative to a traditional 401(k) plan are similar to the pros and cons of a Roth IRA relative to a traditional IRA.
In both instances, the Roth option makes sense if your income, and therefore your tax rate, is likely to be higher in retirement than it is during your working years. Alternatively, if your tax rate is more likely to fall in retirement or stay the same, then, holding all else equal, a traditional IRA may make more sense because you'll be able to use tax savings now to generate gains that are taxed at a lower rate later.
Another advantage that Roth 401(k) plans offer over traditional 401(k) plans is tied to estate planning. If you're saving money to pass along to your heirs rather than to generate income in retirement, then a Roth 401(k) plan could be the better choice. That's because traditional 401(k) plans require investors to take minimum distributions beginning at age 70.5, while Roth 401(k)'s don't. Consequently, since you're not forced to take distributions from your Roth 401(k), and withdrawals therefrom are after-tax, you could conceivably pass along more money to your heirs by using one.
Oh, and another thing
Regardless of whether you decide on a Roth 401(k) or a traditional 401(k), what matters most is that you pick one and contribute as much as possible to it every year.
Thanks to the compounding of interest, the more money that you invest early on, the bigger the impact on your financial future. Consider this point. If you were to invest $200 per month for 40 years and earn a hypothetical 8.5% return per year, then you'd end up with a portfolio worth $709,664. Invest that same amount over 30 years and your portfolio would be worth just $298,126 -- less than half of what it would've been worth if you'd started 10 years earlier. That makes for a pretty compelling argument to take advantage of these plans as soon as you can.
