- What is a 401k?
One of the uncomplicated ways to save for retirement, 401K is an employer-sponsored savings plan. Account holders can automate deposits from their income before or after taxes. In some cases, employers offer matching contributions so workers can have more money in retirement.
There are a few rules concerning how the program can be used:
1. Currently, you can deposit up to $18,500 per year into a 401k.
2. If you are over 50 year's old, you can increase your deposits to $24,500
3. With employer matching, you’re allowed to save up to $55,000 each year.
4. If you want, taxes can be postponed until you are ready to withdraw your earnings.
5. There is a 10% early withdrawal penalty if you take your earnings before the age of 59½, or if the account is aged less than 5 years. This is especially noteworthy for those that are late to start on Roth contributions.
One of the perks of a 401K is your ability to dictate when to pay taxes on your savings. If you want, you can make both pre-tax and after-tax deposits in the same year, or switch between contributions as you please.
- Roth vs. traditional 401k
While both types of deposits can be equally useful, the best course of action will rely on your personal circumstances. There are apparent differences between the contribution types. Typically, the most effective strategy will be to use a combination of both deposits to their maximum benefit.
With a traditional 401k, you can make deposits before paying taxes. This method allows you to reduce your taxable income and put more towards your investment. When you are ready to take payments in retirement, you’ll have to pay taxes on every distribution.
Alternatively, many 401K plans also allow Roth contributions, where you make your deposits with your after-tax earnings. This permits you to pay taxes upfront, so you're off the hook when you need to collect your profits.
You can have the best of both worlds as long as you don’t exceed the yearly maximums. In fact, you’ll probably change your exact contribution style as you move through different stages of life.
Don’t forget to bookmark this page and save it to the home screen of your smartphone or tablet. You can return to compare your options as you progress through your career. If you find this page useful, please promote us on social media using the share feature. Then, follow us on Facebook and Pinterest to stay up-to-date with our infographics and personal finance advice.
- Which one is right for me?
Like most people, you probably want to reduce your tax burden as much as possible. Since each deposit has different tax implications, it’s worth exploring your options. Traditional deposits provide a tax break now, while Roth deposits grant a tax break later in life.
First, you should consider your future earning potential. If you think you might be making more in the future, it’s likely you’ll pay more tax in those years too. As a result, Roth contributions can be more appealing. You’ll pay current tax rates, which could cost you less now than when you’ll need the savings. With Roth contributions, you don’t have to worry about your retirement income pushing you into a higher tax bracket.
Roth contributions can also be a good idea if you are concerned about where future tax rates are headed. You may want to pay known rates now, instead of gambling on taxation in your later years. This can be particularly beneficial if you think things will stay relatively the same with your income.
By contrast, many workers can be at the peak of their career and are expecting to make less money in retirement. The result of this could place an individual into a lower tax bracket. If you believe that you'll be paying less tax in the future, traditional deposits will be more attractive. You’ll pay some taxes in retirement, to put away more of your hard earned money now.
Plus, with traditional deposits, you’ll gain valuable tax breaks when you are in your high income earning years. It’s worth re-investing those tax savings into an IRA, or a high-interest savings account, so you don't end up overspending.
- Using the calculator
The calculator is very straightforward to use. It is designed to model the difference between Roth and traditional 401k deposits based on your financial situation. You’ll have to add a few details about the contributions you can make, to get an accurate estimate of your future account value. Let’s review this together.
Step 1. In the first section of the calculator, you can add your retirement plan information. Be sure to include your current age and the age you intend to retire. You can use your keyboard or the arrow features to make this input easier.
Step 2. On the third line of the calculator include the amount you want to contribute to the account each year.
Step 3. The first checkbox gives you the option to invest the tax savings from traditional deposits. If you would like to learn the value of investing your tax savings, check off this box.
Step 4. The following checkbox allows you to increase your future contributions to the maximum allowed. If you intend to deposit your full yearly limit in coming years, make sure to select this box.
Step 5. Next, you’ll need to expand the second part of the questionnaire by clicking on investment return and taxes.
Step 6. Once expanded, you can add the annual rate of return on your investments. Make to adjust your rate of return downwards to balance any account fees, investments costs, or reporting expenses to get an accurate estimation of your earnings.
Step 7. Finally, you can add your current income tax rate, followed by what you expect your tax rate to be in retirement.
Step 8. Proceed to your results.
- Your results
Once you have completed the questionnaire you can view your results in the form of smart prompts, graphs, and tables.
Immediately to the right of the inputs, you’ll find a smart summary of your total contributions, and the years you have until retirement. Verify this information for accuracy before continuing to the reports.
Below the inputs, the system will provide you a suggestion of whether Roth or a traditional account will be better according to your financial circumstances. For more detailed information, like how much you can save up, please view the integrated reports.
The first tab provides a comparison of your earnings until retirement. View Roth contributions in blue, along with traditional deposits in green. You can hold your mouse over any point on the graph to get an exact reading of your account balance at that time.
The second tab, totals at retirement, will show you the total value of your 401k account based on the years you have left to save. Here you can view your account balance by retirement using Roth deposits (in green), or traditional contributions (in blue). Taxes are already factored into the final numbers so you can contrast your options easily.
The third tab, results summary, provides you with a synopsis of your calculations. See your total contributions, the taxes you might owe, and the value left for you at retirement. For a more detailed perspective of your account balance each year, proceed to the last tab.
Under 401k balances by year, you can view an itemized summary of your account balance each year according to each type of deposit. You'll notice all of your annual deposits, plus their value after your investment earnings. If your deposits are $3,000 and your plan makes a 7% return, your account value will be $3,112.57 in the first year. If you pay close attention, investing your tax savings can really give your savings a boost.
With this information, you should get an idea of how to make the most of your retirement plan. You should return as your finances or income changes, to see if you should alter your contribution style.