Question

Benefits of traditional and Roth 401(k) plans

Traditional 401(k) versus Roth 401(k)
Rajiv has decided to contribute to a savings program. He can open a traditional 401(k) or a Roth 401(k) and has determined that he can afford a $13,200 contribution. Rajiv's salary is $82,500 per year, and he is in the 25% tax bracket.
If Rajiv decides to go with a traditional 401(k), his contribution amount will be
And the amount offset via a reduced tax bill will be
17, instead, Rajiv decides to go with a Roth 401(k), his contribution amount will be
And the amount offset via a reduced tax bill will be
Assuming all the same facts, suppose that Rajiv decides to open both 401(k) plans, spitting what he can afford
plans
contribute equally between both
Under this scenario, Rajiv's contribution amount will be
And the amount offset via a reduced tax bill will be
When Rajiv retires, which plan's monies will he be able to exclude from taxable income?

Answer 1

A traditional 401(k) provides tax savings now as contributions are made pre-tax, leading to a tax bill reduction which in Rajiv's case would be $3,300. Contributions to a Roth 401(k) are made with after-tax dollars, meaning no immediate tax bill reduction, but withdrawals during retirement are tax-free. If Rajiv contributes to both plans, he receives a tax offset from the traditional 401(k) and tax-free retirement withdrawals from the Roth 401(k).

Step-by-step explanation:

Understanding Traditional vs Roth 401(k) Plans

Rajiv is considering two types of retirement savings options: the traditional 401(k) and the Roth 401(k). Choosing between these plans depends on when he prefers to pay taxes on his retirement funds. With a traditional 401(k), contributions are made with pre-tax dollars, which reduces his taxable income for the year the contributions are made. This means that if Rajiv contributes $13,200 to a traditional 401(k), his taxable income will be reduced by that amount, saving him 25% of $13,200 which is $3,300. However, withdrawals during retirement will be taxed as ordinary income.

On the other hand, the Roth 401(k) is funded with after-tax dollars. This means Rajiv pays taxes on his contributions now, and his current tax bill remains unchanged. The benefit comes later, as withdrawals from the Roth 401(k) during retirement are tax-free. If Rajiv splits his contributions equally between both plans, he will still receive a tax offset on the traditional 401(k) portion, but not on the Roth 401(k) portion.

When Rajiv retires, the money withdrawn from the Roth 401(k) is the portion he can exclude from taxable income, providing a tax-free source of retirement income, assuming he complies with the plan's rules.