With a new job often comes lots of new benefits. One of those benefits usually being a retirement savings plan. Many companies will sponsor investment savings accounts that you have the option of contributing to. These are called a 401(k).
There are two main types of 401(k)s. A typical 401(k) and a Roth 401(k). We’ve detailed the differences below.
A 401(k) is an employer-sponsored retirement savings account. It allows employees to contribute a certain amount of their paycheck to it before taxes are taken out. This is the key thing to note here. While you do not pay taxes on the money you invest up-front, you will have to pay taxes on it when you take it out upon retirement.
Often, employers will match a certain percentage of your contribution to your 401k as well, an added benefit to investing in this type of plan. This is the most popular type of employer-sponsored retirement plan in America.
With a 401(k), you decide exactly how your money is invested. A majority of 401(k) plans are made up of mutual funds- compiling stocks, bonds, and money market investments. One downside to this type of account is that you may not take money out of it until you meet any of the following requirements:
- Upon retirement, death, disability or separation from service with the employer
- At the age of 59½
- When the employee experiences a hardship, if the plan permits hardship withdrawals
- Upon the termination of the plan
It is meant to be a retirement savings plan, so if you take money out before meeting the above requirements, you will be hit with a 10% early distribution penalty.
For 2017, the maximum amount of compensation that an employee can contribute to a 401(k) plan is $18,000. If you are over the age of 50, you are also permitted to make additional catch up payments of up to $6,000.
A Roth 401(k) is also an employer-sponsored retirement savings account. However, it allows employees to contribute a certain amount of their paycheck to it after taxes are taken out. While you have to pay taxes on the money you invest up-front, you will not have to pay taxes on it when you take it out upon retirement.
Choosing Between a Traditional 401(k) & Roth 401(k)
The biggest difference between a Traditional 401(k) and a Roth 401(k) is the taxation. A Traditional 401(k) allows you to contribute part of your paycheck before it is taxed, but when you go to take it out years from now, you must pay taxes on your total contributions as well as anything you earned over those years. Alternatively, anything you contribute to a Roth 401(k) is taxed up-front, and you do not need to pay taxes on it when you withdraw the money down the line.
If you believe you will be in a higher tax bracket at retirement age than the one you are currently in, it may be a good idea to look into a Roth 401(k) plan. Paying taxes on your contributions now while in a lower tax bracket, will mean paying less than you would at retirement age as part of a higher tax bracket.