Understanding the differences between the two retirement plans
Photo by Aaron Burden on Unsplash
A 401(k) is a tax-advantaged, defined-contribution retirement account offered by many employers in the United States to their employees. Its name comes from a section of the U.S. Internal Revenue Code. The section of the Internal Revenue Code that made the 401(k) possible was put into law in 1978 through the Revenue Act.
Today, the 401(k) has grown into the most popular way to save for retirement. There is approximately $6.4 trillion in assets in 401(k) accounts as of 2019.
The basics of a 401(k) is that employees can make contributions to their accounts through automated payroll withholding. In some cases, an employer may match an employee’s contribution up to a certain amount to incentive them to contribute to their 401(k).
As of 2020, contribution limits for an employee in a 401(k) is $19,500 per year for employees under 50 and $26,000 per year for employees over 50. Also, as of 2020, contribution limits for an employer in an employee’s 401(k) is $57,000 per year for employees under 50 and $63,500 per year for employees over 50.
The age of 59.5 is the set age in which an individual can withdraw money from their plan without having to pay a 10% early withdrawal penalty. Internal Revenue exceptions for the early withdrawal penalty include death and disability.
When it comes to the 401(k) itself, there are two main types, the traditional 401(k) and the Roth 401(k). Both have their advantages and disadvantages depending on what you are looking for.
Note: I am not a financial advisor. I do not know your financial situation. I am sharing this information for educational purposes only.
A traditional 401(k) involves making contributions pre-tax, meaning that you are not taxed in the present for any contributions you make. Any earnings within a traditional 401(k) are tax-deferred.
When it comes time to withdraw money from your traditional 401(k) after you have reached the age of 59.5, that is when you will pay taxes on your contributions and earnings. A traditional 401(k) is subject to income taxes at the time of withdrawal.
With a traditional 401(k), you do not have to worry about paying taxes now, but you will in the future.
A Roth 401(k) involves making contributions post-tax, meaning you have already paid taxes on the contributions you make. The Roth 401(k) was established in 2001 with the passing of the Economic Growth and Tax Relief Reconciliation Act of 2001. It is named after William Roth, U.S. Senator from Delaware who sponsored legislation creating the Roth IRA in 1997. Employers were given the option to implement the Roth 401(k) in 2006.
The Roth 401(k) took some time to gain usage. Today, it is offered by most employers alongside the traditional 401(k). When it comes time to withdraw money from your Roth 401(k) after you have reached the age of 59.5, no taxes are required on your contributions and earnings. Taxes are required on earnings in the case of an early withdrawal.
With a Roth 401(k), you pay taxes now so that you do not need to worry about paying taxes in the future.
When it comes down to picking between a traditional 401(k) or Roth 401(k), it boils down to your tax preference. Would you rather be taxed later or now? The good thing about a 401(k) is that if your employer offers both a traditional 401(k) and Roth 401(k), you can choose to split your contribution between the two. The maximum contribution you can make is still $19,500 per year if you are under 50 or $26,000 per year if you are over 50.
When it comes to employer matching, it is sometimes confusing to understand. Since most employers will not be contributing the maximum of $57,000 per year for employees under 50 and $63,500 per year for employees over 50, it is important to understand what your employer match means.
With employer matching, the matching can be either a partial match or a dollar-for-dollar match. In a partial match, an employer may match up to 50% of what you contribute up to 10% of your salary. That means that your employer will match up to half of what you contribute, but no more than 5% of your salary. In a dollar-for-dollar match, an employer may match up to 5% of your salary dollar-for-dollar.
In understanding the differences between a traditional 401(k) and Roth 401(k), you are further solidifying your long-term financial success. If you are employed, starting to save for your retirement should be something you plan sooner than later. If you no longer want to be connected to a 401(k), there is always the option to rollover your 401(k) into an IRA.
Check out The Tunji Letter to stay connected.