So last week’s post was pretty simple since it was week one, it was how to set up an effective budget that should be easy to maintain with a little effort. This week I am taking the training wheels off and diving into a subject I received a question about, what’s the difference between a traditional 401k and a Roth 401k. So let us begin….
Traditional 401k: This is the 401k that is taken out of money BEFORE taxes are taken out. Since the money is taken out before taxes are applied, this LOWERS your taxable income, so you get to keep more of your money, a major benefit! Most large companies match a partial amount of the money that you contribute, for example if you contribute 10% of your income they might match 50% up to 10%. You should ALWAYS contribute up to the amount that they match, if you do not you are LOSING free money, yes I said FREE MONEY! There is a maximum amount you can currently contribute and that is $18,000 per year (it was increased this year). The major drawback to 401k is there is a major tax hit if you withdraw money before the age of 59.5, so once you put that money in it is there to stay ( or should stay!)
Roth 401k: It offers majority of the benefits of the traditional 401k except it comes out AFTER taxes so it does NOT lower your taxable income. The primary benefit of a Roth 401k is since the money comes out post taxes, when you are able to withdraw it the money it is not taxed again. The maximum amount of money you can contribute to this type of account is $5500, unless you are over 50. The Roth is great if you think you will be in a different tax bracket when you retire, kind of hard to figure but it is possible.
In closing, the Traditional 401k and Roth 401k offer majority of the same benefits but one comes out pre-tax and the other comes out after taxes. There is also a vast difference in the amount you can contribute every year. I do not think there is a “best” option that will vary from person to person BUT I will say you should be putting away more than $5500 per year (if possible), this could lead to a mix of traditional and Roth 401k contributions.
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