Understanding 401k and Roth 401k

Many people wonder how a 401k or a Roth 401k works. This article will explain some of the advantages and disadvantages of both. Let's take a look at each, how they work, and what you can expect.

The most important thing to remember is that both plans are used as a retirement vehicle. Many employers offer this to their employees. Some employers will even match up to 50% of what you pay in. Every dollar that you put in means 50 cents contributed by your employer. If your employer offers this, you are really in a winning situation. Where else can you make 50% on your dollar? Better yet if you can put 8% into your 401k, then your employer is putting in 4%. That is like getting a 4% tax free raise.

If possible, it is best to maximize your contributions. However, if you can't, you will still do fine. When the market is down, some folks want to pull back on their contributions. However, every time you make an investment, you are still making money up front. Don't fret if the market goes down. When it does, it just means a better buy on some stocks at a cheaper rate. The only time it really hurts is if you are retiring before they go back up. Remember the market always has ups and downs. It is a way of life. If you can diversify, do so. This just means don't put your eggs all in one basket. Try to divide your stock into some aggressive, semi aggressive, passive. Another way to look at is risk. Some are high risk,medium risk, and low risk.

Try to avoid just stocking up in your companies stock. Why? A good example is Enron. A common rule is don't hold more than 10% in your company. Another thing to consider is that small company stocks out perform larger companies in the long run. Also, think global. Do your homework. If you can invest in some stock outside the US borders, do so. How much should you invest globally? Most professionals recommend at least 30%.

Now lets compare the regular 401k to the Roth 401k. What is a Roth 401k? It is a 401k treated like a Roth IRA. On a Roth401k, the taxes are paid up front. A 401k has the taxes deferred until later. It is assumed that taxes will rise over time. So a Roth is taxed at the rate now while a 401k is taxed later. It is a decision you make on taxation. Do you want to be taxed now or later? Since the Roth is rather new, you may not have a choice in what you want because your employer doesn't offer it yet. A Roth 401k helps you if you are in a lower tax bracket. If you are young, it gives you more time for your account to grow and compound tax-free. It lets you diversify your tax situation by drawing from your account depending on your situation when you retire. The Roth401k doesn't have a tax limit like the Roth IRA does.

Keep this in mind. If you are going to retire in less than 5 years, it becomes an unqualified distribution and is subject to taxation. So it would not be worth your while.

In 2010 this law will be up for renewal by congress. You won't lose your money but, it could mean using traditional versions for new contributions.

How much will the IRS let you contribute to your 401k in 2007? You can contribute $15,500 and another $5000 catch up limit. The $5,000 catchup is only for those 50 years of age or older. Keep in mind also that employers can set a limit also on what can be contributed. An example might be that an employer may let you only contribute 8 or 10% of your salary. That would be a lot less than what the government allows.

If you are over 50, your employer may let you catch up. Then you might be able to match up the contributions to what is allowed and no more. No higher than what the IRS allows. They have a schedule for each year.

Lastly, stay up to date. The rules that govern both the Roth401k and the regular 401k change from time to time. Uncle Sam is going to get his fair share. However people are always looking for a fair way to affect a change that can better everyone.

Source: Dustin Woodard