Roth or Traditional IRA or 401(k)

One key difference between a traditional and Roth 401(k) is taxes.

With a traditional 401(k), your contributions are pretax:  they generally reduce your taxable income, lowering your tax bill in the year you make them.  But your money doesn't avoid taxes entirely; you will pay income taxes on any money you withdraw from your traditional 401(k) in retirement.

A Roth 401(k) is exactly the opposite.  Contributions are made after tax, with money that has already been taxed, but you generally don't have to pay taxes when you withdraw from your account.

Essentially, you need to choose between taking a tax deduction on contributions made today or withdrawing contributions and earnings tax free in retirement.  The key is to get the tax deduction when you think your taxes are going to be the highest.  In general:

  •   If you think your tax rate will be significantly higher when you retire then it is now, a Roth 401(k) may make sense, because withdrawals are tax free.
  •   If you think your tax rate will be lower in retirement that it is now, a traditional 401(k) may be more appropriate, because you will pay a lower tax on your withdrawals.

 

 

 

 

 

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