Let’s start with the basics: What is a 401(k), and what the heck is a Roth 401(k)?
Simply put, a 401(k) is a retirement savings plan sponsored by an employer, and it comes with some potential valuable tax benefits. You can invest the money in your 401(k) account, so there is risk involved but also reward in the form of potential investment growth that can help you keep up with our even outpace the rate of inflation.
It gets its funky name from a section of the tax code.
A 401(k) is just one kind of tax-advantaged retirement savings plan − a 403(b) is similar if you work for a specific type of employer. It can help you build long-term savings while deferring taxes until you’re ready to withdraw the money.
You work hard for your money. Why not make your money work hard for you?
Traditional vs. Roth 401(k)s
There are two different kinds of 401(k) plans, and not all employers offer both kinds.
The differences come down to the tax benefits attached to each.
With a traditional 401(k), you can get one potential tax benefit right away: You tell your employer to contribute a portion of your pre-tax pay to your 401(k) account, and you don’t have to pay taxes on that money until you withdraw it much, much later.
Because you contributed money straight from your pay to your 401(k), your take-home pay is smaller, so there’s less money for the government to tax each year that you contribute.
With a Roth 401(k), the tax benefit comes later. If you haven’t heard of a Roth 401(k) until now, don’t feel too bad. Roth 401(k)s have only been around since 2006. More than half of retirement plan sponsors offer the Roth option, according to a survey by the benefits consulting firm Willis Towers Watson, but less than 10% of plan participants who can contribute to a Roth 401(k) actually do it.
You may want to consider contributing to both a Roth 401(k) and traditional one though. You don’t get any tax breaks for contributing to a Roth 401(k), but years later, when you’re ready to retire, you won’t be taxed on your withdrawals as long as you’ve had your account for five taxable years and wait until you’re older than 59½ to withdraw.
That’s a big difference compared to a traditional 401(k), because withdrawals from a traditional 401(k) will be taxed like ordinary income.
Whether you like it or not, unless you’re still working for your employer into your 70s, in most cases you’ll be required by law to start withdrawing a certain amount from your 401(k)s every year (known as taking required minimum distributions or RMDs) once you turn 70½.
So if you’re in a great-paying job now and think you might be in a lower tax bracket after you retire and stop working, you might want to take the tax benefits now and contribute to a traditional 401(k). If you have a healthy amount socked away in your traditional 401(k) and think you’ll have some hefty RMDs in the future that could boost your income, you might consider switching some of your contributions to a Roth 401(k).
You don’t have to choose one or the other: If both a traditional and a Roth 401(k) are available to you, you can contribute to both. Just know that in 2017, you can contribute a total of $18,000 across any traditional and Roth 401(k)s you own (plus an extra $6,000 in so-called catch-up contributions if you are at least age 50). Contributing more than that isn’t allowed and comes with its own tax penalties.
If you are familiar with a Roth IRA (Individual Retirement Arrangement), you may be happy to know that unlike a Roth IRA, there is no income limit for contributing to a Roth 401(k).
What to know with either kind of 401(k)
With either kind of 401(k), the money in your account that you invest can grow tax-deferred, meaning you don’t have to pay any income taxes on any interest, dividends, or capital gains in your investments while they’re sitting in your account.
To encourage employees to contribute, some employers offer to match at least part of your contributions. Putting enough into your 401(k) each year to trigger the match is like getting a really valuable participation ribbon: Some people even say it’s like getting free money, although vesting provisions may apply, meaning you have to stay at your job long enough to get all or some of that employer contribution.
There are a few things you should know about 401(k)s to avoid paying hefty penalties or taxes.
If you take money out of your 401(k) before you're 59 1/2 years old, you’ll potentially have to pay income tax on the withdrawal, plus a 10% tax penalty.
Your employer may allow you to make a hardship withdrawal under certain circumstances without penalty, but the withdrawal is still subject to income taxes, and it can still be subject to the 10% penalty if it doesn’t meet the exceptions outlined by the IRS.
Taking out a loan from your 401(k) can be risky and costly too.
All that to say, make sure you can afford to contribute to your 401(k) before you send money there.
For instance, you may want to pay off high-interest debt or build your emergency fund first. And if you have big expenses coming up, like a wedding or family reunion, you might want to keep that money in the bank because if you have to withdraw money from your 401(k) to pay those bills, it could cost you in taxes and penalties.
How much you may want to contribute
You and your budget will determine how much to contribute, but a good goal may be 10% of your pay. If you can’t afford to contribute that much because of big upcoming expenses or smaller day-to-day bills, then just start simple by contributing what you can.
Re-evaluate your situation every year, and boost your contributions as life allows.
Retirement is a journey, and so is the road to get there. Start simple, and enjoy the ride.
Things to Consider:
• If you have paid off your high-interest debt and already have an emergency fund, consider contributing at least enough to trigger any matching contributions your employer might offer.
• If you’re ready to max out contributions to your 401(k), the limit in 2017 is $18,000 across all 401(k)s you might have (plus catch-up contributions of $6,000 if you are 50 or older.)
• No matter how much you contribute, give yourself some credit for just getting started.
Please note, neither Transamerica nor its agents or representatives provide tax, investment, or legal advice. Consult with and rely on your own independent tax and legal advisors and financial professionals regarding your particular situation.