December 7, 2015

When it comes to limiting your taxable income; pension plans are great first steps. I recommend that whatever plan you choose you always try to contribute the maximum. The sooner you start contributing the maximum the better because it builds up over your working life and you can take advantage of the compounding tax free. If you’re faced with the decision of whether to invest in a 401k or a Roth 401k, the following will explain key differences.

Which is Better: 401K vs. the Roth 401k

Which is Better: 401k vs. the Roth 401k

With the traditional 401k you can contribute for up to $18,000 for 2015 and if you’re 50 or older you can contribute an additional $6,000 so that your total can be $24,000. The advantage with the traditional 401k is that you get the federal and state tax deductions up front and the earnings and appreciations build up tax free. The main disadvantage with the traditional 401k is that all contributions, earnings, and appreciation are taxed when you start taking it out at retirement. However, the Roth 401k doesn’t allow a federal and state tax deduction up front. Similar to the traditional 401k, the earnings and appreciation build up tax free. However the main advantage with the Roth 401k is that all contributions, earnings and appreciation are not taxed when you start withdrawing at retirement.

Which option is better? It depends on your preference and tax situation. Personally, I like the traditional 401k because I like the tax deductions up front. Because tax rates are high right now and they might not get any lower, I want the tax deduction up front. Although I should mention that studies show that you will end up in a better financial position by choosing the Roth 401k. For example, come retirement, depending on your tax bracket, with a traditional 401k, every $100,000 you withdraw could be a 25% to 35% less, after taxes. The preferable option may be to do a combination of both. For example, 50% into a traditional 401k and 50% into a Roth 401k so that you get some advantages of both.

If you have any follow up questions you may contact me directly at elawrence@grfcpa.com.