What is a Traditional 401k?

traditional 401kis an account, provided by your company, where you may place pre-tax money into. The main purpose of the program is to save for retirement. There are equivalent accounts for non-profits (403(b)) and government sectors (458(b)). The name does not come from the fact that you should put $401k in it before retiring, but instead comes from where it is outlined – in the Internal Revenue Code, section 401(k). The plan was conjured up in 1978, and was intended to give taxpayers a break from taxes, and encourage citizens to save for retirement.

As of 2015, you are allowed to place up to $18,000 into a 401k account per year. Great! A tax haven for hiding my money from Uncle Sam. Sounds too good to be true…so what’s the catch?

The Catch

There are severe restrictions behind taking money out of your 401k before 59 1/2 years of age. An excise tax of 10% is applied on top of the regular income tax if you decide to prematurely pull any money out.

Additionally, 401k money you put in isn’t completely tax free. You still have to pay a 7.65% tax that goes towards social security and medicare.

Lastly, when it does come time for retirement and you start drawing money out, it is taxed as regular income. Thus, eventually you do have to pay taxes on the money, but you still pay less since some of that money will be in a different tax bracket.

Advantages

The main advantage is that you don’t have to pay tax on the amount you put in. Thus, this can result in a higher tax return since the amount of taxable income per year is lower.

Another great benefit is that you can control how your money is invested within the 401k account. Your company will give you a list of different investment options that allow you to choose between different types of stocks and bonds, along with money markets.

Of these options, there are target-date funds, which are combinations of stocks and bonds that gradually become more conservative as you approach retirement.

Hands down the greatest benefit of the 401k program is that some companies will match you up to a certain percentage of your salary. For example, if you’re on a $50k salary, and your company does a 3% match, they will give you up to $1.5k, as long as you also put up $1.5k of your own. That’s free money!

Is it too late to start saving?

No! In fact, the best time to start saving is now! The rule of thumb is to save at least 15% of your takehome pay. If this seems to be too much for you, try 10% for now, and slowly increasing up to 15% within a few years.

Roth 401k

You may have heard of another type of 401k – the Roth 401k. The only difference here is that you’re paying taxes before putting it into your account. In turn, the money grows tax-free.

So should I be contributing to a Roth 401k or Traditional?

A general rule of thumb is to contribute to your Roth 401k as much as you can when you’re younger. The logic behind this is that since you’re being taxed at a lower rate when younger (assuming you have a lower-paying job when you’re younger), you should take advantage of your low tax rate. Once you’re approaching your retirement years, you should move steadily towards contributions to a Traditional 401k.