Retirement may seem a long way off right now, when you’re in your 30s.
With your career plans on track to take off, relationships stabilizing, the excitement of acquiring your first home still fresh, and your plans for starting a young family becoming a reality, this period seems to look bright and rosy for a long time to come.
But it’s never too early to start thinking of retirement and saving for the Golden Years. Starting early means you get a lot more flexibility and time to put together a nest egg.
There are several great options available and choosing the right one can be challenging. A professional financial expert can certainly point you in the right direction, no matter when you decide to think about retirement and pensions.
What Is 401(k)?
Sub-section 401(k) of the Internal Revenue Code refers to accounts that are employer-sponsored defined-contribution pension plans.
Though they are well-established and popular today, surprisingly just a few decades ago, they were relatively unknown.
In 1978, the US Congress passed the Revenue Act (1978) which contained Sub-section 401(k) that enabled employees to bypass being taxed on compensations that were deferred. However, this section hardly caught the eye of tax experts.
The breakthrough came in 1980, when a tax-consultant, Ted Benna researched the section and his own company became the first to offer the 401(k) plan to his employees.
The following year, the IRS put out new regulations that enabled funding of their pensions through payroll deductions via 401(k). And the rest like they say, is history.
The way that 401(k) works is:
- If you and your employer meet the eligibility requirements, you can enroll in the plan
- Contributions are made through your payroll before taxes and your savings are allowed to grow tax-deferred
- This helps you lower your current taxable income
- When you begin to make withdrawals in retirement, these are considered to be taxable income
- There is a maximum limit set by the IRS annually, based on your age
What is Roth 401(k)
Congress passed a new Act in 2001 called the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). A part of this related to a new retirement savings plan that combined features of the original 401(k) and the Roth IRA which had been in force for some time. Employers could opt for this plan from 2006 onwards.
How Roth 401 (k) works:
- You can take advantage of the company match on employee contributions
- Income tax is imposed on the amount contributed
- Withdrawals are not taxed
- The maximum annual contribution limits are fixed by the IRS
- There are no income criteria for individuals on contributions
- Participants must compulsorily make minimum withdrawals (distributions) after they reach age 70.5
Comparing Roth 401(k) and a Regular 401(k)
These two plans have a lot in common, although they differ significantly on several crucial aspects. Your decision is based on whether you want to pay your taxes now or defer them till your retirement.
Taking a look at the similarities first:
- Both are workplace-centric and employer-sponsored retirement savings plans
- You can have the contributions directly deducted from your paycheck
- Both have the option of a company/employer match to your contribution and nearly all the big companies in the country are enrolled in this plan
- Contribution limits are the same in both. Under the 2021 regulations, the traditional annual contribution limit for 401(k) is $19,500 even if you’re contributing to both. If you’ve crossed age 50, the limit goes up to $26,000.
- You can switch between the two quite easily and also divide up your contributions between them
Where They Differ
The main point of difference is the time at which you are taxed. In the traditional 401(k), your contributions are made pre-tax. This means your current gross adjusted income is lower. You can get your tax breaks right up front, and this is a big help when you want to lower your current income tax liability. Till you begin to make withdrawals, your money can grow tax-deferred. This hurdle has to be crossed when you start withdrawing – at this point, you’ll have to pay taxes at the current rate and you may also be hit by state taxes.
However, in the Roth 401(k) plan, the contributions are made post-tax. There is no impact on your current income. The employer contributions are segregated into a pre-tax income and taxed during withdrawal.
Your withdrawals are taxed as regular income under the traditional 401(k) plan, whereas you’re not liable to pay taxes on qualified withdrawals after retirement under the Roth 401(k).
The withdrawal rules are also slightly different for both plans. Under the traditional 401(k), all withdrawals and earnings attract taxes. You are penalized for withdrawals made before age 59.5 if you don’t meet the exceptions laid down by the IRS. In the case of the Roth 401(k), withdrawals are not taxed provided you meet the IRS criteria. That means if you’ve held the account for more than five years, you’ve crossed age 59.5 and/or the withdrawal is made following disability or death, the withdrawals are not taxed.
The Roth 401(k) plan is great for people who are young and have the confidence that they will be in a higher income-tax bracket in the future. If you’re closer to retirement age, or the 59.5 age limit, you will not be able to withdraw any money till the account has been held for five years or more.
The Roth 401(k) plan is also a good choice for estate planning if you have a large legacy to leave for your heirs. If the plan is at least more than five years old, your heirs will not have to pay income taxes on distributions from the Roth 401(k) plan inheritance.
Many people prefer the Roth 401(k) plan because it makes them feel emotionally secure that they won’t have to see a big part of their hard-earned and painstakingly built-up nest egg given away in taxes as is the case with the traditional 401(k) plan. When you’re still working, putting away 15% contribution to a Roth 401(k) plan is much easier and you don’t feel the pinch of taxes.
The good news is that it’s not an Either-Or situation. You can enroll for both and based on your situation year by year, you can make the appropriate contributions and take advantage of both.