Sunday, October 23, 2011

401K vs. Roth 401K

401K vs. Roth 401K

By Keith Bunn Jr.
October 23, 2011

Both the traditional 401Ks and Roth 401Ks is, as it was explained to me, “a coat” to protect your investment from the bitter cold of taxes. It is NOT the investment.

Most of us know what a 401K is. It is a way to invest pre-tax money through your workplace for retirement and when you reach 59 ½ years old, you are able to withdrawal that money without paying penalties for early withdrawals. However, because traditional 401Ks are pre-tax, meaning the money was taken out of your paychecks before it was taxed, Uncle Sam will want his cut when you start your withdrawals.

A Roth 401K is different in the way that your money from your paycheck is invested after taxes are taken out and it will grow TAX FREE. Which means that when you start withdrawing that money at 59 ½ years old or older, you will not owe taxes on it because you already paid the taxes up front
Now whether or not your company matches, the tax free part of a Roth 401K is a big deal. Because it is the earnings of those investments that will make up the majority of your nest egg, not what you put into it.

It is always wise to take a company match on either the traditional 401K or the Roth 401K up to the percentage the company offers. For the simple fact that at the time of the match, you just doubled your money, or close to it depending on the percentage of the match. That’s kind of return is hard to beat in any kind of investing. But the company match of the Roth 401K is a pre-tax match. Which means you will have taxes due on the matching portion of that nest egg but what you put into it will be tax free.

So to give you an example…

If you have $3 million in a non-matching, traditional 401K. the taxes on $3 million will be about $1 million. Which leaves you with a $2 million nest egg.

If you have $3 million in a non-matching, Roth 401K. There are no taxes due because it grew tax free. Which leaves you with a $3 million nest egg. Because of the tax free portion of the Roth, I think you would agree that a Roth 401K beats a traditional 401K hands down.

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