Most companies today will provide you with two options: a Roth 401(k) or a traditional 401(k). You may be sitting there saying, “401(k), Roth, what does it mean?“
You choose how much you want to contribute from your salary, the actual investments, and how often you would like to rebalance your investments. This is a company provided plan that allows you to take money out of your paycheck before taxes and place them in your 401(k). After you make these choices, your investments will grow and you cannot take your money out until the age 59.5 (as of 2015).
Roth 401 (K):
You make the same investment choices, but this time your money grows tax free and goes into your Roth 401(k) after you pay taxes on your paycheck.
If you have the option to choose, go with the Roth 401(k).
Advantages of Traditional 401(K):
Contributing to this plan will reduce your taxable income in the current period. For example, if you make $50,000 and contribute $8,000 to your plan, the government taxes you on only $42,000 because you don’t have to pay tax on the initial contribution. Your money grows tax free until age 70.5 when you are required to take Required Minimum Distributions (RMD) out of your account.
Disadvantages of Traditional 401(K):
Even though your money grows tax free, when you reach age 70.5, you must go through a RMD. A RMD requires you to withdraw a certain amount of your money from your account and transfer it to your bank or other investment account each year so Uncle Sam can reach into your pockets for some tax money. The government taxes you each year on these distributions.
Advantages of Roth 401(K):
Contributing to this plan will not reduce your taxable income in the current period, but you will not have to pay taxes when you withdraw money in retirement. At age 59.5, you can begin withdrawing money from your account with no penalty. You also pay RMD with these type of accounts, but these RMD are not taxed.
Disadvantages of Roth 401(K):
You will pay higher taxes in the current period. For example, if you make $50,000 and contribute $8,000 to your plan, you still pay taxes on the whole $50,000.
So What Do I Choose?
A Roth 401(k) has more beneficial long term advantages for many reasons, with certain tax assumptions. I take the pessimistic opinion of many people that taxes will generally increase over time, but the optimistic opinion that people will also earn more money over time. Earning more money as you age will put you in a higher tax bracket, making paying taxes in the current period on less income a better option. Investing in a traditional 401(k), watching your money grow, and then having to pay taxes on your RMD when you’re likely to be in the highest tax bracket should be your second option when a Roth 401(k) is available. Either way, investing in any 401(k) plan will improve your long term financial position.
Read Tom OShea’s answer to, “What’s the Difference between a Traditional 401(K) and a Roth 401(K)?” on Quora.