Most employers offer a traditional 401(k) or Roth 401(k) or in some cases both. Employees can contribute to both accounts, and employers can opt to match a portion of the employee’s contribution. To best meet your retirement goals, it’s important to understand both options.
Key Differences in Taxation
Cody Rickaway, Wealth Advisor at Integrated Wealth Management, LLC., states, “The main difference between a Roth 401(k) and a traditional 401(k) is how they are taxed.” Employee contributions to a Roth 401(k) are made with after-tax dollars meaning the money is paid into the retirement account after income taxes on those earnings have been deducted. Contributions to a traditional 401(k) are made with pre-tax dollars. Pre-tax means the money invested into the traditional 401(k) is not taxed immediately, instead, the contribution defers taxes until withdrawal.
“There are benefits to both retirement accounts,” says Rickaway. A pre-tax or traditional retirement account can be a smart choice if you plan to withdraw funds gradually and expect to be in a lower tax bracket during retirement. If you are considering a large purchase in retirement, like a second home or a cabin, you may want to invest your money in a Roth 401(k) because the money has already been taxed. Rickaway says, “Let’s say you withdraw $100,000 from a traditional 401(k) after you retire, you will be taxed on this amount according to your tax bracket.”
Employer Contributions
When it comes to planning for retirement, you also need to understand how employer contributions are taxed. Typically, employer contributions are tax-deferred. Tax-deferred means you are not taxed until you withdraw the money. Understanding the tax-deferred treatment of employer contributions can significantly impact your retirement planning strategy.
Rickaway says, “Tax diversification is a strategy that involves spreading your investments across different tax categories.” This approach can help you manage your tax liabilities more effectively and align your financial strategy with your personal goals and objectives. Because each person’s retirement goals differ, consult a financial advisor to make the most of your contributions. It's always wise to consult with a financial advisor to make the most of these contributions in your retirement plan. There is no one-size-fits-all approach to retirement planning.
If you are looking for a wealth advisor, you can contact Cody Rickaway, CFP®, CIMA®, RICP®, AIF® at
cody@integratedwm.com or by calling his office at 608-785-0069. RICP conferred by the American College.
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