The following is a guest post by Greg McFarlane
Still ambivalent about starting a 401(k) or a Roth 401(k)? If you are, give me a chance to guess why.
Maybe you love the immediate gratification of spending money now while ignoring the prospect of having to move in with one of your kids when you’re 80. Maybe you know a guy who knows a guy who owns a diamond mine in West Congo, and you’d rather invest your money there.
Enough!!! Go to whoever handles 401(k)s at your workplace and sign up today.
What’s the big deal about a 401(k)?
The second-biggest selling point about 401(k)s is that they grow tax-free. The biggest is that they go with you when you switch jobs, which you will.
If you’re uncertain how 401(k)s work, no problem. (And come to think of it, why wouldn’t you be uncertain? They don’t teach this stuff in school.) A 401(k) is just a retirement investment account set up through your employer. Like any other employee benefit, it’s an incentive to get you to work there, similar to an on-site massage therapist or monogrammed shirts.
Seriously though, 401(k)s are now so popular that any employer of decent size that doesn’t offer them is putting itself at a competitive disadvantage. Besides, it’s not as though they cost employers that much to provide access to.
How does it work?
With a 401(k) you have several thousand dollars a year deducted from your paychecks (up to $16,500 in 2010, $22,000 if you were born before 1961.) That money grows over the next few decades, and you cash out at age 59½. Not 60, not 59, but 59½. Even the person who selected that arbitrary number probably couldn’t tell you the logic behind choosing it over an integer.
Some employers offer “matching funds” if you have enough money deducted from your checks. Don’t fool yourself, the employers aren’t doing this to be generous. They did the math, and they’re just offering to match your 401(k) contributions in lieu of paying you a higher salary.
The 401(k) money from your employer is tax-deferred, as is any interest or appreciation that accrues from it. As for what you contribute – maybe the taxes on it are deferred, maybe they aren’t. Which brings us to the two types of 401(k). But first, gather ‘round and listen to a one-paragraph story:
When 401(k)s were founded in the early 1980s, the idea was that you deducted your contributions from your income for tax purposes. The agents of the IRS would tax whatever interest and appreciation accrued on your 401(k), but not until you started receiving the payments, once you were 59 years and 6 months old.
But I want my tax benefit later!
In 2006, 401(k)s got a qualifier: they’re now called “traditional” 401(k)s, to distinguish them from the new Roth 401(k)s, named after the late U.S. Senator William Roth. The two varieties of 401(k) are the direct descendants of IRA and Roth IRAs respectively: those are the Individual Retirement Accounts you set up on your own (hence the word “individual”), without your employer having anything to do with it.
IRAs of both types have been largely supplanted by 401(k)s since the invention of the latter, primarily because 401(k)s have bigger limits and are much easier to buy into if you’re a salaried worker. If you’re self-employed or make most of your money via something other than regular paychecks, an IRA is still the way to go.
The difference between a Roth 401(k) and a traditional one is that with the former, you pay taxes on any income it generates when you earn it. But once you receive the payments, they’re tax-free, as are any interest and appreciation.
The catch is that you can only get a Roth 401(k) if you make under $110,000 ($160,000 if you’re married and file your taxes jointly.) Also, many employers find that the additional paperwork required to accommodate Roth 401(k)s isn’t worth the hassle.
But assuming you have a choice, which one to get?
Do a Roth 401(k) until you make too much money to qualify, then switch to a traditional. That doesn’t mean you’ll be taking the funds from the Roth and moving them to the traditional. That’s illegal. Rather, you’ll just be carrying two accounts instead of one, one of which will lay dormant, just gathering interest.
If you start with a Roth, the years of tax-free growth while your salary gradually rises will make a big difference come the midpoint between your 59th and 60th birthdays. However, if you plan on making the exact same money every two weeks until you retire, then stay in a traditional 401(k). Then, marvel at how you made it to this point in life with so little ambition.
And in case it isn’t obvious, contribute at least enough to qualify for any employer match. The money’s just sitting there, so you might as well take it. It’s okay to walk by a penny on the sidewalk without picking it up, but not tens of thousands of dollars.
Greg McFarlane is an advertising copywriter who lives in Las Vegas and Lahaina. He recently wrote Control Your Cash: Making Money Make Sense, a financial primer for people in their 20s and 30s who know nothing about money. Buy the book here (physical) or here (Kindle) and reach Greg at greg@ControlYourCash.com.