Roth vs. Traditional 401ks

By now, most Americans understand that at the very least, they should be participating in their employer’s defined contribution plan, most commonly offered in the form of a 401(k). But some companies offer two forms of these plans: the traditional 401(k) and the Roth 401(k). You thought deciding how much to allocate to your plan and then researching and electing the investment funds to support it was confusing enough, but here you are, faced with yet another option for safeguarding some retirement funds. Let’s break it down just a bit more.

What’s the difference?
The primary difference between a traditional and a Roth 401(k) is simple but significant. With a traditional 401(k) plan, your contributions grow tax free, and you pay taxes on the withdrawals; Roth 401(k)s, on the other hand, work in precisely the opposite way, as you pay taxes on your contributions but not on your withdrawals.

Additionally, Roth 401(k)s tend to be seen as more of an estate planning tool, since they do not necessitate that you to take required minimum withdrawals (RMDs) once you reach age 70 ½, as you must do with traditional 401(k)s. This allows you to leave your funds untouched for as long as you want after retirement, letting your investment grow tax free all the while.

Which is right for you?
This is a conversation best held with your financial advisor, as you must determine whether the back-end payoff of a Roth 401(k) outweighs the benefits of traditional tax deferral on the front end, but generally speaking, it depends largely on where you are in life and into which tax bracket you fall.

If you’re relatively young with an eye toward saving for retirement and you don’t earn a great deal of money, a Roth 401(k) may be worth exploring, as the upfront tax-savings benefits wouldn’t be as significant to you as a tax-free payout in retirement. Conversely, if you’re an established earner in a higher tax bracket, getting up-front tax-advantaged treatment is probably best, making the traditional 401(k) your most likely option. This is especially true for individuals who expect to be in a significantly lower tax bracket when they retire.

You can even double-dip.
If your employer does offer both types of 401(k) plan, you can split your contributions between the two if you so choose, as long as your combined annual contributions do not exceed 2012’s annual limit of $17,000. If you’re 50 or older, that limit jumps to $22,500.

With so many options, there is a 401(k) plan, or a combination of the two, that is ideal for your current situation. But before you make your decisions, be sure to weigh these considerations carefully, especially if you don’t speak with a financial advisor regularly.

Photo courtesy of: sovereignman.com

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How To Take Advantage of Your 401(k)

So, you’ve been saving for retirement for years, spending your entire career penny pinching and saving every morsel you can, hoping to live out your years in a stress-free, fully-funded lifestyle.  You started young and have been saving ever since.  Most importantly, you have invested in the magical program people call a 401(k) at your company and have gritted your teeth as you watched a bit of every paycheck funnel into it.  Good for you!  You have taken an initiative that many people avoid.  As a reward for your planning and diligence, you will be granted, no, not three wishes, but three tips to using your 401(k) in the most productive way.

Many people go through the effort of investing in their 401(k) plans, but make critical errors in how they invest into it.  There are few ways to make sure that the money you pay in now, will give you the best payout in the future.

Tip 1:  Make significant contributions.  Many people think that their 401(k)’s future is mainly dependent upon the performance of the investments, but these people are mistaken.  If you invest a small percentage of your income in well performing funds, you won’t find the success that investing a higher percentage in lower performing funds will afford you.  Of course, this means a bigger chunk of your valuable paycheck, but if you can cut back and live frugally now, you will have more wiggle room later.  Also, it’s critical that you invest enough to take full advantage of any match programs from your employer.  That match offers you tax-free money on a shiny silver platter.  Investing only a small percentage of your income into your 401(k) leaves this platter sitting on the table, out of your reach.

Tip 2:  Invest for growth.  You are cutting back, buying the generic cereals and stepping away from the gator skin shoes so that you can put all you can into your 401(k).  If you are making those sacrifices, you owe it to yourself to get the most from that money.  This can be done by making smart decisions inside of your funds.  Like with any investment, this means taking on a bit of risk.  This doesn’t mean playing Russian roulette with your funds, but being too conservative can almost negate the extra effort you are making.  One way to do this is to invest more of your 401(k) money in stocks.  If your investments face average market performance, putting a higher percentage of your investment in stocks, over bonds or cash, you will find yourself in a better position in the long run.  Of course, this involves balancing your risk with the reward you are looking for, but if you consider getting a little riskier with your investments, you could find yourself with a lot more money later.

Tip 3: Avoid undoing all your hard work.  Borrowing from your 401(k) can be one of the most costly loans you can find.  By taking your money out of the fund, you will be costing yourself the growth that money would have given you.  Life brings about surprises and emergencies that may force you to borrow from your 401(k), if this happens, make sure you plan for the company to take the loan payments from your check.  If you find yourself wanting money for expenses, such as a new car, look into a personal loan or home equity line of credit for financing.  Competitive rates on these options will leave you in a better long term position.  The second part of this tip is to avoid cashing out your 401(k) when you leave a company.  Much of your hard earned money will be whisked away by penalties, fees, and growth loss.  There are a few different ways to avoid simply cashing out when you switch jobs.  Many companies allow you to roll over your balance into their plans, which means your investments and growth will hardly skip a beat with the changeover.   You can also roll your plan into an IRA, which offers a broad range of investments not offered with many other retirement plans.  The easiest option may be for you to simply leave your money in the current employer’s plan if you have a significant amount already saved.  The bottom line is that borrowing from your 401(k) or cashing out early can wipe away a lot of the money that you have been so painstakingly saving.

 

Photo courtesy of bemanaged.com

If you have been planning for your retirement and investing with your 401(k) you have put yourself on a path to success.   By doing these few simple things you can make your path smoother and that success brighter.  You are already going through the effort to save for your future, keep these tips in mind and your effort will be much more worthwhile.

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