The Difference Between A Traditional And Roth 401(k)

By: Eva Sadej

As much as you may want to spend your starting salary on your kids, your family, a new home, vacations, or maybe even just food, rent, and utilities, you will be significantly worse off in retirement if you do not plan effectively. If you are twenty-something, with the miracle of compounding, you are in a prime place to begin saving and should take steps now to secure your financial future for when you will no longer be able to work.

The easiest first step you can take is to set up a 401(k). Starting early is key. It is ideal for new employees to save 10% of their income, but starting with just 4% or 5% until you get a raise is just fine. And if your company does not allow you to start a 401(k) immediately, make sure to note the date your waiting period ends and not blow it off.

Open an account now especially if your employer has a match program. An employer match of 50% of contributions can boost your retirement savings by thousands of dollars a year. No investment will give you that high a stable return.  Whether or not your employer has a 401(k) match plan, you should contribute for good financial planning, a tax break, and for the sake of tax-deferred growth. Your maximum contribution limit to a 401(k), Roth or Traditional, is $16,500 and the employer match does not affect this amount. [1]

Quoting from another one of our articles on 401(k)s: “Setting up a 401(k) is a piece of cake. You check off a box on a form at your company, and instantly there’s money taken out of every paycheck and deposited into a retirement account in your name. You can determine the amount you want to put away, and many companies even have a program where they match your contribution up to a certain percentage (usually 6% of your salary). Sounds great right? You check a box, and you’re on your way to a more comfortable retirement: the very definition of a set-it and forget-it system.”

If you open a Traditional 401(k) there are significant tax incentives to opening an account. For pre-tax contributions, if for example you make $50,000 and contribute $5,000 to a 401(k) this year, you will only recognize $45,000 as income on your tax return in a traditional 401(k) plan. You will, however, be paying taxes on that income once you retire and withdraw.

If you are hesitating in the choice between a traditional and a Roth 401(k), you may want to consider a Roth 401(k). The distinction is as follows: contributions to a Roth 401(k) are with after-tax income. If you expect to be in a higher tax bracket when you retire than when you are young and working (which is usually the case) it is wiser to pre-pay the taxes. Another argument comes from estate planning: if you want to secure your family’s financial future, it is more responsible for you to pre-pay the taxes on your 401(k) account as you expect your family wealth to grow and higher tax brackets to follow. And if you are unsure about which tax bracket you will fall in when, it is a safe bet that taxes in the United States on the whole will rise over time.

Be critical of default options. Most companies enroll their employees in target-date funds in traditional 401(k) accounts. You will be given periodic opportunities to make changes, and you should take advantage of them, making sure that your allocations in your 401(k) meet your objectives and are balanced against your holdings in any other accounts you may have – IRAs, 529s, brokerage accounts, CDs, and the like.  You want to make sure that your overall portfolio across all your accounts is well balanced. In particular, pay attention to the fees associated with your investments, as these can erode tens of thousands of dollars of value over time.  Remember, the magic of compounding means that anything you pay out in fees today means lots more in foregone gains when you retire and start drawing down from your 401(k).

If you haven’t opened a 401(k) yet, do it now. A quick chat and a few checkmarks is all it takes.