A 401(k) is a retirement savings plan that is usually employer-sponsored. This means you, as an employee, elect to have part of your earnings placed into an individual 401(k) account, which is managed by your employer. Generally, you can select from among a variety of different investment options for your account, usually a mix of different types of mutual funds. Often, you can also use your account to invest in your employer’s stock. Some employers also “match” part or all of their employees’ contributions by putting additional funds into the 401(k) account.
Since 2006, there have been two types of 401(k)s available (although not all companies offer both types) – the traditional 401(k) and the Roth 401(k). With a traditional 401(k), your contributions are tax-deductible , meaning that the 401(k) is funded with pre-tax dollars and tax-deferred, meaning that you don’t pay income tax on the money in the account until you withdraw it. This type of 401(k) is especially attractive to higher income earners who get a significant benefit from the up-front tax break, and who prefer to postpone the income tax until their 401(k) withdrawals.
A Roth 401(k) works in the opposite way – you pay income tax on money contributed to your Roth 401(k) in the year that you put the money into the account. But, the money also grows tax-deferred, and qualified withdrawals from the account – including investment income – are tax-free. This plan is attractive to lower income earners who don’t make enough to miss the tax break during the year of initial contribution but who benefit a great deal from not having to pay taxes during retirement.
If your employer offers both traditional and Roth 401(k)plans, you may want to divide your retirement savings between the two types of plans so that you can take advantage of the benefits of both.
A new law that became effective January 1st, allows the owner of a traditional IRA or 401(k) to convert these accounts to a Roth IRA. Tax is paid on the amount converted, but future qualified withdrawals are tax-free. For this year only, you can choose to pay the tax this year, or defer the income equally to your 2011 and 2012 tax years. For more information, contact a qualified attorney, tax or financila advisor.