Penny Tabor, Vice President of Retirement Services at People's United Bank, talks about options for your 401(k), including Roth IRA.
Q. Many 401(k) plans are now starting to offer the option to do a Roth deferral in addition to the traditional Pre-tax deferral. Can you explain to our viewers, Penny, what the difference is between the two?
A. Absolutely Steve. The traditional pre-tax deferral is just that. The deferral is calculated before Federal and State taxes are withheld. This results in you taking away tax dollars that would have gone to the Federal and State to help fund your retirement. So remember, whatever percentage deferral you do pre-tax, you really won't have that percentage less in your paycheck because of this. In addition, it brings your taxable pay down, so you also pay less in taxes at the end of the year when you go to file your returns. It is a double benefit.
Q. So, how does the Roth deferral work?
A. Unlike the pre-tax, this deferral is made after tax so you don't get the tax break now. However, as long as the money sits in the Plan for a minimum five years (and by the way, the five year clock starts ticking with your first Roth contribution and not every single one) and you do not touch the money until you are age 59 ½ or older, there will be no taxes due on the earnings made. Of course, the money you put in isn't taxable as you paid the tax on it back when you contributed it.
Q. How does someone decide if Pre-Tax or Roth is right for them?
A. That is a decision you should make with your tax or financial advisor. Many factors come in to play regarding this. Typically, younger folks who are currently in a low tax bracket and will accumulate a sizable account balance down the road and highly compensated individuals who cannot do a Roth IRA contribution are the two types of folks who are interested in doing Roth contributions. There are income limits on making Roth IRA contributions but this is not applicable for Roth 401(k) contributions. Just remember, it's not an either/or decision, you can split your contribution between both traditional Pre-Tax deferrals and Roth deferrals. Check with your 401(k) provider to see how often they allow deferral changes.
The most important thing is to make 401(k) contributions. Let's be honest. Who's this for? For you so you can retire and do the things you want to do instead of having to do.