Regular 401K vs Roth 401K - The Basics
By CHM on Feb 21, 2008 in Featured, Roth 401K, Traditional 401K
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Over the next week or so I’m going to be taking a closer look at 401K plans.
I’ll be focusing slightly more on the Roth 401K (as opposed to a regular 401K), since few people I come across are familiar with it. Today we start with the basics.
A 401K plan is a salary reduction plan that allows employees to defer a portion of their salary (through payroll deductions) towards retirement. For 2008, employees are limited to salary reduction contributions of $15,500. For employees over the age of 50, the law now permits “catch up” contributions of an additional $5,000 for 2008.
Keep in mind, the above paragraph describes the general characteristics of any 401K. The way your salary reduction contribution is treated (from a tax standpoint) is what determines whether it’s a regular 401K contribution or a Roth 401K contribution.
Regular (traditional) 401K
A regular 401K contribution (which is the payroll deduction that the overwhelming majority of Americans make) is a pre-tax contribution. So if you contribute the maximum for 2008 ($15,500) you are not paying any taxes on this money, therefore reducing your taxable income by that amount for 2008.
You will pay taxes on this money when you take it out in the future; these future distributions will be included as ordinary income.
Roth 401K
In a Roth 401K, you are making an after tax contribution. You are entitled to make the same salary deferral contribution ($15,500 for 2008) but the monies you contribute are included in your taxable income for that year. Since you are foregoing the tax break now, you will pay NO TAXES on future distributions.
Current state of affairs
Unfortunately, you can’t just tell your employer which way you’d like your contribution treated, at least not yet. Your employer has to have an existing Roth 401K alternative in place, in order for you to be eligible to contribute.
Since most employers (to their detriment) are not very proactive with retirement plans, many do not offer employees the Roth 401K option (only the traditional 401K). If you’re frustrated by this fact, then start off by contacting someone in your HR department to do something about it.
A few closing observations:
- A traditional 401K has many of the same characteristics as a traditional IRA
- A Roth 401K has many of the same characteristics as a Roth IRA
- 401K payroll deductions are automatic
- An employer matching contribution can’t be added to your Roth 401K, it must be made to a regular 401K
- The total employee contribution for 2008 is $15,500 ($20,500 for those 50 or older), no matter how you divvy it up between a regular 401k and a traditional 401k
Back tomorrow with 8 things you need to know about a Roth 401K for 2008…
Tags: Roth 401K, Traditional 401K
Frugal Dad | Feb 21, 2008 | Reply
Excellent summary. I’m assuming there is a Roth 403(b) or equivalent for those of us working for a non-profit or educational institution?
CHM | Feb 21, 2008 | Reply
Hey FD,
Yes sir, there is a Roth 403(b) that caters to employees of non profits, public school districts, etc… it’s more or less the same thing as a Roth 401(k).
Learning | Feb 21, 2008 | Reply
Thank you about talking about this. I’ve never paid too much attention to this before, just signed up for auto payments and ignored it.
You’ve talked before about the ceiling on salaries for contributing towards a 401(k). Up until this year this has never been an issue for me. If I understand the rules correctly, after $99,000 you cannot contribute the full 15500 anymore. But is the $99000 before or after taxes? And if we cannot contribute to the 401(k), can our employer still contribute (mine does regardless of my contribution)? And does that mean that I should now be sending it to the Roth 401(k) instead?
CHM | Feb 21, 2008 | Reply
Hi Learning,
The eligibility limitations apply to contributions in a Roth IRA, not Roth 401K or regular 401K. You will be able to continue to make automatic 401K payroll deductions regardless of your income level.
And the eligibility limits for the Roth IRA are based on your AGI (adjusted gross income)