02 Jan Types of 401(k)s – Which One is Right for Me?
Did you just start a new job and keep hearing about this thing called a 401(k)? Or maybe you have been working for a while, but you are just now learning about it? Either way, a 401(k) is a gold mine for your investment future. Here we will cover the different types of 401(k)s, how they work, and which one is best for you!
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What are 401(k)s?
A 401(k) is a tax-advantaged retirement account offered by many employers to their workers. It is considered a “qualified” retirement plan by the government, which means that it gets special benefits compared to other self-guided retirement plans. Okay, sounds neat, but how does it work?
How Do 401(k)s Work?
In a 401(k), employees make contributions automatically through their company's payroll system. Essentially, you can choose to have a chunk of your pay taken out of your paycheck and invested in your retirement plan. Then the employee decides what they want their savings to be invested in (options provided by the company), such as stocks, bonds, mutual funds, Target-Date funds, and Guaranteed Investment Contracts.
The real gem of 401(k)s is the employer match! Many employers will match your contribution up to a certain point. For example, if you were to contribute $1, your employer may add on 60 cents. That is 60 cents of free money! That doesn't seem like much, we know; that is why we need to look at a year's worth of contributions!
As of 2020, employees can contribute $19,500 to their 401(k). So, let's go back to that 60 cents above. If you were to max out your yearly contribution of $19,500, and your company matched you 60 cents for every dollar. That would mean…drumroll, please! You would get $11,700 of free money!
$19,500 x $0.60 = $11,700
Wow! Why wouldn't you want to do that? By the end of the year, you would have contributed $31,200 to your retirement plan! Now each company is a little bit different, but at the end of the year, the maximum amount allowed for employee and employer combined to contribute is $57,000! Dang, that is a lot of money!
Now, to be open and fair, not all companies offer that awesome of a rate. The average company offers around a $0.50 match for every dollar, but some companies also offer more. Speaking with your company about their policies will give you a clear look at how they manage their 401(k)s.
What is the difference between a Traditional 401(k) and Roth 401(k)?
When looking through your company's retirement plan options, you may have seen that they offer two different plans, a traditional 401(k) and a Roth 401(k). At the beginning (back in 1978), there were only traditional 401(k)s, but in 2006, the Roth 401(k) became available. While not all companies offer a Roth 401(k) YET, they are on the rise. With these two options, you need to know the similarities and differences! Let’s take a look!
Similarities between Traditional 401(k)s and Roth 401(k)s
Both Traditional 401(k)s and Roth 401(k)s must be run through your employer's company; this isn't something that you can do solo. If you wanted to do that, you would want to pursue an IRA. Also, with both accounts, most companies will do a contribution match (that free money we talked about earlier).
In both account types, there is a maximum contribution limit. As of 2020, the contribution limit was $19,500 per year.
In both traditional 401(k)s and Roth 401(k)s, you can start withdrawing at age 59 ½. As well, in both accounts, you must begin withdrawing by age 70 ½, no exceptions.
Differences between Traditional 401(k)s and Roth 401(k)s
In a traditional 401(k), the contributions you make are pre-tax. Whereas with a Roth 401(k), your contributions are made post-tax (if you need a quick lesson in pre-tax vs. post-tax, click HERE). To break this down, with a traditional 401(k), you are doing a tax-deferral. This means that you will pay taxes when you pull the contributions out during retirement.
It is the opposite with a Roth 401(k); you already paid your taxes on the money when you put it in, so when you withdraw the money during retirement, you will pay ZERO taxes on your contributions and earnings. The only money you have to pay taxes on is the employer match.
If you were to withdraw early from either account, you would face a 10% penalty fee. The difference is how the fee is applied. In a traditional 401(k), you would be penalized 10% on everything. In a Roth 401(k), you are only penalized 10% on your earnings. You can take any contributions you have made out at any time.
In both traditional 401(k)s and Roth 401(k)s, you can begin withdrawing for retirement at age 59 ½. However, with a Roth 401(k), there are a few extra details.
First, to withdraw from a Roth 401(k), you must have had the account for at least 5 years. If you are starting your account in your twenties, this isn't a problem; however, if you start your account at age 57 and you want to withdraw at 59 ½, you won't be able to. You would have to wait until you are 62 to withdraw.
Second, you may be eligible to withdraw early due to a disability, or your family can withdraw in your place if you were to die. Super fun, right? Just kidding, but it is something to consider.
Plain and Simple
We understand that what you just read was a lot of information, so here is a comparison chart to make it easier! Green is where they are similar, and yellow is where they are different!
|Traditional 401(k)||Roth 401(k)|
|Done through your company||Done through your company|
|Company will provide contribution match||Company will provide contribution match|
|Max contribution = $19,500||Max contribution = $19,500|
|Earnings = Tax-deferred (pay later)||Earnings = Tax-free (pay now)|
|59 ½ to withdraw||59 ½ to withdraw with 5 years of account holding|
|10% penalty on early distribution||10% penalty of early distribution|
|Must withdraw at age 70 ½||Must withdraw at age 70 ½|
What if I Make a LOT of Money?
If you make a lot of money, you may be considered a highly compensated employee (HCE). Since the government doesn’t want individuals to get unfair benefits, the IRS uses an actual deferral percentage test (ADP). The test essentially compares an HCE with a non-highly compensated employee (NHCE). In this test, they make sure that the total contribution of the HCEs does not go over 2 percentage points over the NHCEs. If they do, the company has to take corrective action or face getting fined. What this all means is that an HCE may face limits on what they can contribute.
What if I Switch Jobs?
It is highly likely that over the course of your working life you will switch companies or careers, what happens to your 401(k) then? There are four options that you can choose:
The first and WORST option is to withdraw the money. This is a pretty bad idea, because not only will you have to pay the 10% penalty and taxes, but it will also stop your forward progress. We highly recommend that you DON’T do this unless you really need it for some tragic expense. If that were the case, we would hope that you have an emergency fund set up.
2. Move it into an IRA
The second option would be to roll it over into an IRA. If your new job does not offer a 401(k), this may be a viable option. However, we want to warn you that it can be a bit complicated, so you would want to speak with the brokerage firm you have your IRA with before doing anything. They will help you figure it all out!
3. Leave it
The third option is to simply leave it. If your previous company had a well set up retirement system that you liked, there is no harm in leaving it there. Sadly, you won’t be able to add to it anymore, but it will be waiting for you once you retire. As with any type of investment, it’s important to check in on your 401(k)s at least annually to rebalance and restructure it as necessary. Just make sure that you remember it when retirement comes, or you make sure that your heirs have written knowledge about it in case of your passing.
4. Move it to a new company
If you are moving to a new company that offers 401(k)s, you can roll it over to your new job. It is similar to moving to an IRA, but this way, you can continue building it up at your new job. This would be the option that we would suggest if it is available to you.
What if I am Over 50?
The government understands that not all individuals have had the opportunity to take advantage of their 401(k) for their whole career, which is why they allow for “catch-up.” If you are over 50, you can add $6,500 to your annual limit as a way to get caught up for the lost time.
Can I do a Traditional 401(k) and a Roth 401(k)?
Simply put, yes. However, that maximum contribution limit doesn't change if you have both. You can only contribute $19,500 no matter what. So, if you have both accounts, you will have to split it between the two.
Which One Should I Choose?
If you are struggling to choose between the two, the main thing you need to think about is taxes. If you would like to avoid paying taxes now and are assuming that you will be in a lower tax bracket during retirement, you would likely choose a traditional 401(k).
However, if you have the ability to pay the taxes now and plan on being in a higher tax bracket (especially with all this saved up money) during retirement, you would want to choose the Roth 401(k).
Dave Ramsey, a famous financial investor, recommends choosing a Roth 401(k). He once wrote, “Imagine getting to your retirement years and watching your $1 million-dollar nest egg reduced to less than $800,000 because of taxes! I don’t know about you, but I’d much rather pay taxes now than see all that money fly out of my hands later. I’m going to miss $100,000 a lot more than I miss a $100 on a paycheck now.”
If that idea aligns with your future plans and mindset, it is likely the best option for you. However, everyone is different. If you are still unsure which method is best for you, consider speaking with your company's retirement representatives and/or with a financial advisor.
Wait! I have a 403(b)!
Relax, it is okay! 403(b) retirement plans are offered by public schools, nonprofit organizations, as well as some churches and hospitals. Having a 403(b) retirement plan is nearly identical to having a 401(k). They both have traditional and Roth options, and almost identical features. The only difference is who the employer is, so no worries! All of the information above still applies to you, just with a different name.
Get Started Today on Your 401(k)!
Whether you decide to go with a traditional 401(k) or Roth 401(k) retirement plan, the most important thing is to get started today. Your company is offering you FREE MONEY to invest in your future, so take advantage of it by investing as much as you can each month! Most investors recommend around 10-15% of your salary to go towards your 401(k) plan with the goal of maxing out the plan by the end of the year. You can do this, and we promise that the reward is sweet at the end!
401(k)s vs. IRAs
While doing research about 401(k)s, it is likely that you have also heard the term IRA. IRAs are similar to 401(k)s, but also very different. If you are curious about which option is best for your investment, read our article on 401(k) vs. IRA – What Should I Do?