My employer offers a regular tax-deferred 401(k) plan and a Roth Individual Retirement Account (Roth IRA). I can contribute to both or only one. Does it make sense to split my contribution up and put funds in both? What are the benefits of doing so?
FPA member Amy Mahlen, CFP®, of Marathon Investments said the following:
“The difference between the two is that money placed into a regular 401(k) is not taxed and therefore lowers what you currently owe on taxes. Any money that is placed in a Roth is taxed regularly, like the rest of your paycheck. When you take money out of a regular 401(k) it will be taxed as ordinary income and if you take it out before 59½ it could also be subject to an additional 10 percent early withdrawal penalty if it isn’t used for items such as education, medical, and the like. Withdrawals from Roths are completely tax-free after the age of 59½ and offer much more favorable terms in regards to taxes if taken out before age 59½.
“Generally speaking Roths are a great tool and very rarely have I not recommended them to someone. If you are saving in a retirement plan, I am assuming you have already put aside money for emergencies in a savings account (three to six months of expenses).
“After you have an emergency fund established, I would recommend contributing to a Roth 401(k) for your contributions. Any match that you employer contributes will be on the regular 401(k) side — please check your summary plan description. The benefits of withdrawals on Roths strongly outweigh the benefit of getting a deduction from a regular 401(k). Especially considering tax rates are at historical lows and Congress has extended those rates for 2011 as well.
“And remember if you use this retirement plan as it should be — at retirement — the last thing a retiree wants to pay is Uncle Sam. Retirees live off a set amount of money from Social Security, pensions, and — with hope — some savings. The ability to tap a tax-free income source in retirement is invaluable.”