Traditional 401k vs Roth 401k: What's Best for You?

Saving for retirement with a Roth IRA or 401k is very important. There are many different ways you can save for retirement and it can get overwhelming for many people when trying to decide which works best for them.

Traditional 401K

When you decide to make contributions to a traditional 401K, your contributions are made with pre-tax dollars. The money is taxed once it is withdrawn from the account. This pre-tax method helps you save more money. Also, employers have the option to contribute a percentage to each 401k plan too, to help increase savings. People can open a 401K account with their employers when they turn 21 years old and choose the percentage of their pre-tax income to contribute each pay period.

Roth 401K

The Roth 401K was developed in January 2006. The contributions to this plan are made with after-tax dollars. That is, the money you invest is already taxed. Once you withdraw the money, it is not taxed. For 2009 and 2010, the maximum amount one can contribute each year is $16,500, unless the person is over age 50 and then the maximum becomes $22,000. Originally this type of plan was set to expire on December 31, 2010, but when President Bush signed the Pension Protection Act of 2006, it solidified this option as a permanent choice.

Which is better?

The best retirement tool is highly individualized and depends greatly on how old you are, how much you contribute and the amount of years you have until retirement. A calculator will help you figure out the savings with each kind of retirement plan based on the annual contribution, your current tax rate, the expected rate of return and the tax rate when you retire.

For example, a 24 year old who contributes $16,500 every year in the 25% tax bracket and plans to retire at age 65, has 41 years until retirement. With a traditional 401K, this person can estimate that she would have around $423,000 for retirement. With a Roth 401K, the same person can estimate that she would have around $504,000 for retirement. Both retirement tools are based on an 8% rate of return with a 15% tax rate at retirement. The Roth 401K seems to be the better option for the 24 year old because it offers more money when it is time to retire.

When a person decides to invest any tax savings from the traditional 401K back into the retirement fund, the difference in funds between the two types of retirement accounts is almost negligible. In the end, the best retirement tool will boil down to the rate of return. There are many online calculators that can be used to determine your individual situation.

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