Your retirement may plan offers two savings options: Traditional (Pre‐Tax) 401(k) and Roth (After‐Tax) 401(k). Each option can offer significant tax advantages to some taxpayers. But who? The answer depends on a number of factors, and some of those factors require predictions of the future.
Traditional (Pre‐Tax) 401(k) Contributions
With a pre‐tax 401(k), contributions you make are taken from your gross pay before taxes are withheld from your paycheck. This gives you a tax break up front, helping to lower your current income tax bill. Your money, both the contributions you make and any earnings on those contributions, grow tax‐deferred until you withdraw your money. At that time, withdrawals are considered to be ordinary income and you will have to pay Federal and any applicable State taxes due at your current tax rate. With certain exceptions, you'll also pay a 10 percent penalty if you're under 59½.
Contributions = pre-tax (Federal/State), avoid taxes now
Distributions = pay tax (later)
Good for = older participants in a higher tax bracket now, lower tax bracket at time of distribution
Roth (After‐Tax) 401(k) Contributions
With a Roth 401(k), it’s the opposite. You make your contributions with after‐tax dollars, meaning there's no upfront tax deduction. After‐tax dollars are the amount that remains after the deduction of all federal, state and withholding taxes. However, when you withdraw your Roth funds, both contributions and earnings are tax‐free at age 59½, as long as you've held the account for five years.
Contributions = after-tax (Federal/State), pay taxes now
Distributions = avoid taxes (later)
Good for = younger participants in a lower tax bracket now, higher tax bracket at time of distribution