Picture this scenario: You have finished a grueling interview process. After days of studying and fielding questions in front of the mirror, you finally get the offer. The job is a perfect fit for you, the salary looks great, and you even get some nice benefits! On your first day, your HR representative asks if you want to take advantage of the company’s 401(k) plan. Immediately questions come to mind. Should I? What are my options? What in the world is this “Roth” word I keep hearing about?
Answering these questions may be as important a step in setting yourself up for a successful financial future as landing the job in the first place. The landscape of retirement accounts is broad, but we are going to focus on two of the most common retirement plans: the 401(k) plan and the IRA, or Individual Retirement Arrangement (usually simply referred to as an Individual Retirement Account). You can think of these as two buckets for your retirement funds. Your 401(k) is a benefit made available to you via your employer, while an IRA is an account you will have to set up yourself. There are some important distinctions to understand.
401(k) plans, unlike traditional defined-benefit pension plans, are ‘defined contribution’ retirement savings plans. The name “401(k)” is a reference to the section of the tax code that permits this type of plan. As an employee, your 401(k) allows you to defer a portion of your salary (up to $22,500 in 2023, or $30,000 if you are over 50) directly to the plan rather than receive it as current income. On top of that, some employers will also contribute to the plan, offering to “match” contributions you make up to a specified amount. Yes, this is often as good as it sounds! As a young investor, you should always try to contribute at least enough to receive the full match offered by your company. It is free money. As long as you work for the company you can continue to contribute funds to the plan. And if you choose to decide at any point to leave, you can take the funds with you by “rolling over” the funds into another 401(k) plan or an IRA. But this raises the question, what is an IRA?
IRAs, unlike 401(k)s, are independent of your employer. You can contribute up to a certain amount of any “earned income” you report ($6,500 in 2023 or $7,500 if you are over 50) to your IRA. These contributions may or may not be tax-deductible, depending on your overall income and participation in other retirement plans. But unlike a 401(k), your IRA is always available to you.
So now you understand the differences between buckets for your nest egg. Next, you will need to consider tax options and choices you have regarding your contributions, because not all contributions are treated the same. In broad strokes, you will typically be deciding between traditional and “Roth” contributions for both accounts. So, what is the difference?
Traditional contributions are pre-tax funds. That means you contribute these funds before paying tax on the income you defer or contribute. Once in your 401(k) or IRA, your retirement savings grow free of current taxes. But isn’t this too good to be true? I can contribute funds to this account and never pay taxes? Unfortunately, that is not the case. Uncle Sam always gets paid. Once you retire, any distributions you take from your IRA or 401(k) that were funded with pre-tax money will count as fully-taxable (“earned”) income on your tax return. In the meantime, though, you are able to shield returns from your retirement savings from taxes, which is a huge benefit!
“Roth” contributions, on the other hand, are post-tax contributions. That is, you pay taxes up front on the amounts deferred or contributed to a Roth retirement account. So why would you do that? Here’s why that might make sense. Since you pre-paid the tax, not only do these funds grow tax free; withdrawals of both principal as well as earnings can be withdrawn completely free of tax in retirement.
The main difference between contribution types comes down to when you pay taxes. That choice, however, can also have a big impact on how much you pay in taxes over time. Generally, the higher your income tax bracket is today versus what you expect it to be in retirement, the more likely you are to benefit from making pre-tax contributions. On the other hand, if your tax rate in retirement is likely to be the same or higher than it is currently, the more likely you are to benefit from making Roth contributions.
When thinking about retirement, both where and how you are contributing your hard-earned dollars are important considerations. One day, these dollars are what will eventually support your future. An advisor at Griffin Black can help you not only understand the type of account to be contributing to (401(k) or IRA) but also if contributions should be pre or post tax (traditional or Roth).