When saving for retirement, you may have the option of choosing between a 401(k) and a Roth 401(k). With these accounts, you can essentially choose how you want to handle the taxes on your retirement savings. You can pay them now with the Roth 401(k) or you can pay them later with the pre-tax 401(k).
The purpose of both of these accounts is to provide you with a way to save money for your retirement. With the traditional 401(k), you set money aside out of your paycheck before taxes are taken out. With the Roth 401(k), you set money aside out of your take-home pay. Once you fund either account, you can choose to invest in securities such as mutual funds or stocks. You can begin taking contributions from your account once you reach age 59 1/2.
Both of these accounts have the same annual contribution limit. As of 2010, you can put $16,500 into a traditional 401(k) or a Roth 401(k). After you reach age 50, the Internal Revenue Service allows you to make a catch-up contribution of $5,500 in addition to the $16,500. This brings your annual contribution limit up to $22,000. If you are interested in being able to put away the most money, the Roth 401(k) is superior. Since you fund it with after-tax money, if you reach the $16,500 limit, you have actually reserved more than that out of your paycheck.
Future Tax Benefits
Both of these accounts could be beneficial to you depending on your situation. If you believe that your tax bracket will be higher when you retire, you may benefit from the Roth 401(k). This would allow you to pay taxes now when you are in a lower tax bracket, then avoid those taxes once you retire. If you make more money now than you will when you retire, the pre-tax 401(k) might make more sense.
Current Tax Considerations
In addition to affecting your future tax situation, choosing one 401(k) over the other also can affect your current tax situation. For example, if you make the full $16,500 contribution to a pre-tax 401(k), this lowers your annual income by $16,500. This could put you in a lower tax bracket now and save you a considerable amount of money on your taxes. If you used a Roth 401(k) instead, you would not get this deduction and you may pay more taxes on all of your income.
Regardless of which type of account you choose, you may be eligible to receive employer matching contributions. Employers often make matching contributions because it allows them to deduct that amount from their taxable income for the year. With both of these accounts, the contributions are made on a pre-tax basis. With a Roth 401(k), the money is kept separately and you would have to pay taxes on it at your marginal rate once you retire.
Even though 401(k)s are traditionally offered through employers, you do have the option to open this type of account if you are self-employed. You can open either a traditional 401(k) or a Roth 401(k) depending on your preference for how you want the taxes to be handled. Either option provides you with the ability to make a much larger contribution to your account. Since you are self-employed, you can make a salary deferral of $16,500 or $22,000 depending on age and you can also contribute part of the profit from your business. The total dollar limit for your annual contribution is $49,000 or $54,500 depending on your age.