On 401Ks
Recently, the topic of 401K retirement accounts came up in a conversation, and my friend and I sighed saying “I have no idea what I’m doing”. This is common among many people. I am no expert, but here’s a bit about what I *do* know.
In the past, people worked at few companies for their entire career. It was common to start working and later retire at the same place, and then receive a pension (a set monthly amount) after retirement as a way for elder you to enjoy life thanks to small contributions younger, working you made over the years.
Few companies give pensions now, and instead use a 401K system. The main exception I know of are the military and government. Even utility and insurance companies are phasing out their pension plans. 401K is similar in concept. You contribute an amount of your choosing from your paycheck each month, and can collect the sum back when you reach a retirement age set by the federal government (currently age 59 ½ or older). Nonprofit orgs’ equivalent of the 401K is called the 403(b) and it works the same. I’ll refer to both of these as “401K” from here on.
Sometimes, the employer/company matches your contributions to your 401K. For example, say I can contribute up to 6% of my monthly salary to my 401K, and my employer matches 50% of that. That means that if I contribute $200 a month for future, elder me, my employer will match and give $100 — free money! — as well.
It’s wise to get as much of that employer’s matching contribution as possible. Right now, I don’t really feel like setting aside 6% (say $200) of my paycheck each month. I’d rather buy something shiny now! But my employer’s free money for future retired elder me is a very good offer that should be maximized. This squirreling away of money will not be in vain.
Roth vs Traditional
Money put into a 401K account can go into 2 types of accounts: Roth, or Traditional. There’s plenty of resources online on what these mean. The big question is, which type (or both!) should I use?
- Roth is better if:
You (or you & your spouse who file taxes jointly) expect to earn more when you retire than you do now. You pay federal income tax on the 401K money saved now, but don’t pay any taxes on it when you withdraw it later. - Most people tend to earn less when they are starting off their career than when they have ended it.
- Which means, if you are young, or before mid-late in your career path, then Roth can be better.
- If you’re 50/50 and not sure how you & your spouse will be earning down the road versus now, you can split your 401K contributions into both Roth and Traditional accounts. It’s not a bad idea to diversify.
- Traditional is better if:
You’re older, closer to retirement age (59 ½), not expecting to increase income much, or not expecting to be changing up to a higher tax bracket.
Happy saving!
Nest Cafe ~ Cafe Nido 