Preparing for retirement is something most people do at some point. If your employer offers a retirement plan, it’s usually worth it to participate. This is particularly true if your employer matches up to a certain amount of your contributions. The retirement plan must conform to the Internal Revenue Service’s withholding and plan requirements.
For a retirement plan to be qualified, the plan document must fulfill the guidelines of the Internal Revenue Code and follow the provisions in the plan. Private-sector employers typically offer employees two 401(k) choices: traditional and Roth. The former is calculated on a pretax basis, while the latter is done on an after-tax basis. 403(b) plans are similar to 401(k) plans but are offered by public schools and specific tax-exempt organizations.
The IRS collects federal income tax, Social Security tax and Medicare tax. You do not pay federal income tax on a traditional 401(k) at the time of withholding. However, Medicare and Social Security tax-withholding apply. When you withdraw your money from the plan, federal income tax is deducted because you didn’t pay the tax when you made your contribution. With Roth 401(k), you pay federal income tax, Social Security tax and Medicare tax when you make your contribution. When you take your money out of the plan, you do not pay any of those taxes on your contributions because you already paid them.
Pretax withholding gives you a higher net income each payday than after-tax withholding. This is because your contributions are taken out of your paychecks before federal income tax is withheld. Let’s say you earn $600 weekly and your 401(k) weekly contribution of $50 is your only pretax deduction. Only $550 of your pay is subject to federal income tax withholding. If you didn’t have the deduction, the entire $600 would be subject to withholding. However, in both situations, Medicare and Social Security taxes apply to the $600.
If you have a Roth 401(k), your calculation is done on a post-tax basis, which means your contribution is made after taxes are withheld. This process does not give you more take-home pay because it does not lower your taxable wages.
Whether a traditional or Roth 401(k) is better for you depends on your situation. If you don’t want to worry about paying taxes on your contributions when you withdraw from the plan, a Roth 401(k) would be ideal. If your financial situation is tight and requires more money each payday, a traditional 401(k) may be your best bet. Note that your employer’s matching contributions are taxed as pretax dollars even if you have a Roth 401(k). Specifically, the match is placed into a separate tax-deferred account. When you withdraw from the plan, the matching contributions are subject to taxation.
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