Company-sponsored retirement plans, such as 401(k) plans, can hold many different types of investments, including stocks, bonds and notes. These investments can generate interest, dividends or capital gains or losses. When income is earned in the plan through the sale of securities, it is invested back into securities by the plan administrator.
Tax-Sheltered Retirement Plans
Many companies offer defined-contribution retirement plans, such as 401(k)s, rather than the defined-benefit plans common in the private sector before the 1970s. This means that they are not responsible for the growth in the plan, only for maintaining it on behalf of the employee. Every plan is different. Some allow participants more say in investment-making decisions than others. One of the main benefits of 401(k) plans is that the investment income that grows in the plan does so tax-free until withdrawn. With certain types of 401(k)s, it is not taxable even then.
In this type of plan, both the employee and employer can make contributions. The employee contributions are tax deductible and the tax withholding on their paychecks is net of the contribution. The employer portion is not taxable to the employee. The investment income grows in the plan sheltered from tax until withdrawn. Every time an individual stock pays a dividend inside the plan, it gets reinvested without tax consequences. When withdrawals are made from the plan, they are taxed as ordinary income, regardless of whether they were contributions, dividends, interest or capital gains. There is no need to track investment income by type in these plans because they are taxed together.
A Roth 401(k) allows the employee to make contributions from after-tax dollars. There is no tax break contributing to the plan, but the employee withdraws from it in retirement without paying tax on any of the accumulated income. It is a permanent tax deferral. Because there are no tax consequences to withdrawals in retirement, there is no need to track dividend reinvestments in the plan. If a plan holder withdraws before she turns 59 1/2, she will pay tax on the income portion of the withdrawal as ordinary income, without reference to the type of income.
Which Investments to Hold
The different tax treatment of the two plans creates a challenge to determine which is better. When you have the choice of both at your workplace, you may be able to set up both and hold different investments in each. Because traditional 401(k) income is taxed at ordinary income rates, you lose the benefit of lower rates on capital gains and dividends. In the end, you may pay a higher tax rate than if you held the investments outside a sheltered plan. If you hold those same investments in a Roth plan, you will never be taxed on them. For many investors, holding interest-bearing investments in their traditional 401(k) plan and dividend and capital gain producing assets in a Roth plan provides the best balance of tax benefits.
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