I wasn’t very good at saving as a kid. Money burned a proverbial hole in my pocket. I liked to get gum when we went to the grocery store because it felt good to spend a dollar. To this day, I tend to be a spender. In fact, in our budget, Bailey (my wife) and I call the money allocated to spending as our “blow funds” because it is for us to literally blow on anything we want. What makes me different from when I was as a kid is that I actually have a budget now to control that spending urge. I’m more future-focused! And part of being focused on the future is saving for retirement. That’s where the 401(k) comes in.
What is a 401(k) anyway? It is a saving system that allows you to invest money you earn so that it can exponentially grow for the future. This is how it works.
A 401(k) is offered by most employers. If one signs up for a 401(k), it gives the individual the opportunity to put a percentage of each paycheck into a retirement account. For me, I have my employer put 10% from each paycheck into my 401(k). This is called an investment because it will grow within the account. Generally speaking, one can expect a 7-10% rate of return on their 401(k) if the money is invested into good growth-stock mutual funds.
This is where the big bonuses of a 401(k) come into the conversation. They have major tax benefits! There are two kinds of 401(k)s: traditional 401(k) and Roth 401(k).
The traditional 401(k) is tax-deferred. This means that one defers paying tax to a later date and thus, the money put into the account is pre-tax. So when an employer directs 10% from an employee’s paycheck into the traditional 401(k), no tax is paid. In retirement, however, taxes must be paid when withdrawals are made.
The Roth 401(k) is similar but the employee pays tax before the employer directs the hypothetical 10% of the paycheck into the account. This means the money used is post-tax.
But when money is withdrawn in retirement, it is not taxed.
Let’s make this easy. Say you are able to save enough for retirement that your 401(k) is able to grow to $1,000,000 (which really doesn’t take much saving). Generally speaking, over a 40-year period with a 10% rate of return, you would have contributed 8% of your savings and the rest of it would be growth. So..
With a traditional 401(k), your contributions would be pre-tax. Thus, you wouldn’t be taxed on your contributions, but when you retired, you would be required to pay taxes on the entire $1,000,000. This means that if you were in a 10% tax bracket, you would lose $100,000 to taxes and would have only $900,000 left.
With a Roth 401(k), your contributions would be post-tax, meaning you would pay taxes on only the contributions. If we assumed once again that you were in a 10% tax bracket, you would pay $8000 in taxes on your contributions but wouldn’t have to pay anything on the growth.
Here’s a summary on taxes paid:
Roth 401(k): $8,000
Traditional 401(k): $100,000
Now tell me, which would you rather pay? And which 401(k) do you think is better?
In some coming blog posts, I’ll cover the amount we want to save for retirement and what we can expect in growth.
I want to know in the comments, are you saving for retirement? What are your dreams for your “golden years”? Bailey and I want to travel. Let me know what you think!