You’re employed and your employer offers a 401(k). You hear your coworkers discussing their 401(k)’s. You know that you have to save for retirement and you already know you want to retire early. So what should you do?
The 401(k) is the first step. Many employers offer some kind of retirement plan and the 401(k) is a very common retirement plan today. The 401(k) has some key features to be aware of. When you contribute to a 401(k), that money is put into a retirement plan that is set aside for retirement.
There are certain exceptions but in general, you will be penalized on any money taken out before retirement age. So once you put money into the 401(k), you want to leave it there until retirement, otherwise Uncle Sam will take an extra bite out of your money.
There are a few important tax rules regarding 401(k)’s. When you put money into the 401(k), in general, you get to deduct that amount from your taxable income on your tax return. Therefore, if you have taxable income of $50,000 and you make a $5,000 contribution to your 401(k); your taxable income will be reduced to $45,000. Since the government gives you a nice break on your contribution, they want you to pay taxes on the money when you take it out. When you take the money out of the 401(k), it is taxed by Uncle Sam and if you take the money out before reaching age 59.5 (again, there are certain exceptions), you will have to pay an extra 10% penalty to Uncle Sam (IRS). How wonderful, right?
For this reason, when you make the decision to contribute to your 401(k), you need to be fairly certain that you will not need that money until retirement. That money is set aside for retirement. In addition, when you reach a certain age, the government is going to require you to take a certain amount of money out of your account every year (they get tax revenue from it so it’s beneficial to them, not you). This is called a Required Minimum Distribution and you must take out at least the amount that the government specifies; otherwise, Uncle Sam will levy a tax equal to 50% of the amount that you were supposed to take out (IRS).
Now you know the basic rules in regards to 401(k)’s; however, life isn’t that simple. There’s another kind of 401(k) that you need to know about. Some employers are offering a newer vehicle called the Roth 401(k). The Roth 401(k) has some key distinctions from the regular 401(k). First is, using the same example from above, if you make a Roth 401(k) contribution of $5,000 and have taxable income of $50,000, you will not be able to deduct your contribution. Therefore, you would still have $50,000 of taxable income even though you put the $5,000 into the Roth 401(k). So what is the point of putting money in the Roth 401(k) then? One of the most valuable aspects of the Roth 401(k) is that as long as you satisfy some IRS rules, you can take money out of the account at retirement age income tax-free (IRS). That means that if you satisfy some IRS rules, all earnings in the account will be tax-free when it comes time for you to retire. That’s pretty amazing! In addition, the government doesn’t require you to take a certain amount of money out of your account once you reach a certain age. You can take the money out as you please, instead of being dictated what to do by the government.
The single most powerful aspect of the Roth 401(k) is that as long as you follow certain IRS rules, you will never share any of that money with the government again. That is even more powerful when you consider our country owes more than $16T in debt. Moreover, with individual income tax rates currently at historic lows (Tax Foundation), what do you think will happen to tax rates in the future? The Roth 401(k) allows you to pay tax on the money you put in now at historically low income tax rates and never pay tax on it again (barring you follow certain IRS rules).
Which should you choose: the traditional 401(k) or the Roth 401(k)? For young people, the Roth 401(k) may make the most sense. If you are in the beginning of your career and in lower income tax brackets, why wouldn’t you contribute to the Roth 401(k) and let that money build up tax-free for many years until retirement? In addition, when you’re currently at historically low income tax rates and the income tax rates are looking pretty dire going forward, why wouldn’t you at least consider the Roth 401(k)? By putting money into a Roth 401(k), you’re more than likely going to create a large tax-free pile of cash that you can use for anything, any time in retirement. The Roth has a lot of attractive features. The traditional 401(k) may make sense if you are in the top income tax bracket and are just downright sick of paying a lot of taxes. That is an easy way to lower your tax bill.
I’ll give you my step-by-step plan. If you have the option of contributing to a Roth 401(k), you should certainly consider doing it. In addition, if your employer is matching your contributions to your 401(k) at $.50 on every dollar up to 6% of your pay, you really should consider contributing 6% of your pay and getting the full value of the match that your employer provides. Once you have achieved the full match, you should consider putting any extra retirement savings into a Roth IRA. A Roth IRA is a similar retirement plan to a Roth 401(k) but it does have a few differences. By putting money into your own Roth IRA, you have much more flexibility in what you do with it. You are not stuck with the investment options that your employer provides.
So in closing, consider contributing up to the full amount of your employers matching into a Roth 401(k) if you employer offers it, because it is free money! It’s a return on your money! Then if you want to save more for retirement, contribute the rest of your money to a Roth IRA in your name. This plan works great for many people but you’ll also have to evaluate your situation. Everyone’s situation is different but surely you should consider the plan I have just outlined. It may pay dividends in the long-run.
Financial Executive, Member FPA
Kaufman Financial Services
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