The Internal Revenue Service encourages retirement savings through a wide range of savings plans, such as traditional 401(k) plans, Roth 401(k) plans and Roth individual retirement accounts (IRAs). Knowing how these plans work, and their various tax breaks, as well as your employer's ability to contribute on your behalf, can help you maximize your tax benefits and retirement savings.
Traditional 401(k) Benefits
A traditional 401(k) plan allows you to defer compensation into a tax-sheltered account through your employer. Unlike an IRA, your employer can match your 401(k) contributions so that you get even more money put into your account, without having to pay taxes on the contributions. Employers can choose to match all or a portion of your contribution, or your contribution up to a percentage of your salary. You do, however, have to pay taxes when you take distributions from the account.
Roth 401(k) Differences
If you make your contribution to a Roth 401(k) plan rather than a traditional 401(k) plan, the contribution limits and matching amounts are the same. When making your contribution, you do not get a tax break on your contributions, but your qualified distributions are tax-free. However, your employer is not permitted to make a matching contribution to your Roth 401(k) plan. Your employer may still make a maximum match, but that matching contribution must be put into a traditional 401(k), rather than a Roth 401(k). Not all employers offer Roth 401(k) plan options.
Roth IRA Alternative
If your modified adjusted gross income does not exceed the annual limits, found in Publication 590, you can also make a contribution to a Roth IRA. This can be done either in addition to your 401(k) contributions, or instead of your 401(k) contribution. The Roth IRA account functions similarly to a Roth 401(k) in that qualified distributions are tax-free. But a Roth IRA has additional advantages in that it never requires mandatory distributions. If you take early distributions, your contributions come out first -- tax-free and penalty-free -- before ever touching earnings, rather than splitting your early distributions between contributions and earnings as required with a Roth 401(k).
Dividing Your Contributions
When your employer offers a matching contribution, this is effectively free money, which is why you should contribute the maximum allowed amount if you can. For example, if your employer matches your contributions dollar for dollar, up to 10 percent of your salary, and you make $60,000, you need to contribute $6,000 to maximize your employer's matching contribution. If you only contribute $5,000, that means that's $1,000 you're not getting from your employer's matching contribution. If you have extra money after maximizing your employer's match, a Roth IRA is more beneficial if you anticipate a higher tax rate in retirement. A traditional 401(k) is more beneficial if you expect to pay a lower rate at retirement.
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