There are two different types of 401k plans that can be used to save for retirement in a tax efficient manner. A 401(k) plan is the tax-qualified, defined-contribution pension that is created under Section 401 of the Internal Revenue Code. It is commonly referred to as a 401k. Many employers set up 401k plans for their employees.
Types of 401k Plans and Retirement Benefits
- Traditional 401(k) Retirement Plan – This is an employer created accounts. The contributions to this account are pre-tax, but the withdrawals (when you retire) are taxable part of your taxable income. Usually your employer will also match a fraction of your contributions up to a certain limit because they achieve a certain tax benefit.
- Roth 401(k) Retirement Plan– This is a retirement account your employer creates for you. The contributions are post-tax, but the withdrawals and the earnings are tax-free. Thus, you will not pay taxes on amounts withdrawn from a Roth 401k in retirement. Usually your employer will also match a fraction of your contributions up to a certain limit.
401k and Roth 401k Tax Information Guide
The best advice for most taxpayers is that if you have a 401(k) retirement plan, you should use it and make monthly contributions because employers will usually match contributions up to a certain limit.
Tax considerations of traditional 401k and Roth 401k plans to consider
- Traditional 401(k) – Since taxpayer contributions are pre-tax, the distributions from the 401k account after you retire are taxable income and taxes might be paid. This is usually to a retiree’s advantage because most people expect to be in a lower tax bracket during retirement. The distributions are restricted and during retirement it is required have to take regular i.e. monthly withdrawals of the same amount each time. It becomes like a paycheck taken from your 401(k).
- Roth 401(k) – Because contributions are post-tax, the distributions from the account during retirement are tax-free. Even the earnings on the account. This is usually not to your advantage because most people are in a lower tax bracket when retired. There are two reasons someone might want to use this account anyway:
- You think taxes are going to be much higher in the future.
- You think you’re going to retire with a lot saved up.
Using a Roth 401k and a Traditional 401k
It usually good to use both kinds of accounts. It makes sense to contribute some of your savings into the Roth 401(k) because it does two things: It makes those distributions tax-free, and more importantly, it lowers your effective income during retirement
Important to note that in a 401(k), investments options are more limited that an IRA and are limited to what your employer offers. Usually they’ll offer a suite of mutual funds, but rarely any individual stocks and maybe some ETFs. This is why many people roll over a 401k plan to an IRA when they leave an employer to access better investment options.