WTF is a 401K?

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If you’ve ever taken a personal finance class, you’ve heard your professor say, “Start saving ASAP.” It’s true. Just think about how nice it’ll feel to not live off off-brand cereal in your golden years. Social security is the primary source of retirement income for senior citizens, but we shouldn’t rely only on social security to fund our retirement. “[For] younger workers who won’t retire for another 40 years, Social Security may no longer be there,” said Anne Triana, President & CEO at financial and wealth management firm Curo Private Wealth. 401K plans are the alternative to relying solely on social security payments.  But what exactly is a 401K? And what’s a Roth 401k?

401Ks are employer-sponsored retirement savings plans that allow both you and the company you work for to contribute to your retirement. Two types of 401ks exist: Roth 401ks and Traditional 401ks. The two options allow you to pay taxes at different times, but both allow for savings to accumulate.

What is a Roth 401K vs Traditional 401K?

The main difference lies in when the IRS imposes taxes. “The Roth 401k accepts after-tax money into the retirement account, and then all withdrawals (during retirement) can be withdrawn tax-free. The traditional retirement plan puts away money on a pre-tax basis, but then the withdrawals during retirement are taxed,” said American University finance professor Jeff Harris. In other words? In a Traditional 401K, the money is not taxed when deposited. Instead, the taxes are imposed at withdrawal. In a Roth 401K, you pay taxes upfront.

Which One is Better?

Some people believe a Traditional 401K is better because you get the tax savings immediately. Let’s face it, a lot of young people just starting their careers need money now. Those who open a Traditional 401K are banking on their contributions growing throughout their working life, so that when they retire, the tax payments won’t be an issue. Those who invest in Roth 401Ks are likely to be already established in their careers and able to afford paying taxes in the beginning, so that when they retire they can be in a lower tax bracket, which is based on how much money you earn.

“The tradeoff between the two depends largely on the tax rates.” explained Harris. The United States has a progressive tax system, which means that high income taxpayers pay higher tax rates. “Young people who might be starting a career, with relatively low earnings (and thus, relatively low tax rates) get the benefit of the Roth account, presuming that tax rates will be higher in retirement—an individual putting money in a Roth therefore pays a relatively low rate before putting money away and avoids the potentially higher rate when taking distributions during retirement,” said Harris. Both choices have their benefits, and both are useful tools in saving for retirement.

Benefits From Employers

Some companies offer their employees a match contribution to their 401K. “[This makes it] so that employees who put away their own money in a 401K can increase their overall compensation by contributing and having the employer match,” said Harris. “The rate of matching might vary, but even a small match can add value to employee compensation. In addition, sometimes the matching provides a big incentive to save for retirement.”

So, make sure you contribute whatever your employer is willing to match. “For instance, American University matches employee contributions on a 2:1 basis (up to a maximum AU contribution of 10 percent of salary). Thus, someone making $50,000 who contributes five percent of the salary (or $2500) to retirement can have AU contribute another $5000,” said Harris. Does that sound amazing or what? “In the case just described, the employee would be taxed on $47,500 but then would have $7500 added to the 401K account for a total compensation of $55,000. Someone not contributing to a 401K would simply make the $50,000,” said Harris. Remember: Don’t leave that free money on the table.

The Takeaway

Start saving as soon as possible. “Put money away little by little, year by year,” said Triana. Ideally, we want to start saving for retirement once we start earning our first steady income. Even a little contribution each month can go an extremely long way. Also, pay attention to employer benefits when handling a 401K. Once you start earning, start saving. You’ll be happy you did.

I am a junior studying broadcast journalism at American University. I am obsessed with my dog and would die to see the Mets win the World Series.

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