In our last blog post, we discussed the basics of 401(k)s: what they are and how you get them. But almost more importantly, what’s in it for you? How can a 401(k) benefit you?
Telco Credit Union is a full service, not-for-profit financial institution serving over 10,000 members. We serve eastern North Carolina, including Tarboro, Rocky Mount, and Greenville, NC. Profits are returned to our members, which are reflected in our ability to pay higher dividends on savings, offer lower interest rates on loans, and provide expanded products and services at less cost.
So let’s get down to it: what’s in it for you?
Many employers offer to match a portion of what you save. The 401(k) perk that gets all the headlines is the employer match. If you work somewhere that offers to toss extra money into your account based on how much you contribute — for example, a dollar-for-dollar or 50-cents-on-the-dollar match up to, say, 6% of your contribution amount — stop reading now and fill out the sign-up paperwork. If you do nothing else, at least contribute enough to your account to nab that free money.
Play around with our 401(k) calculator to see how your savings will grow with a 401(k) — and the difference incremental changes, including any company match, will make over time.
This is a good time to mention there are several types of 401(k) plans, including the two main kinds: the traditional 401(k) and the Roth 401(k). The traditional (or regular) 401(k) offers upfront tax break on your savings. Contributions to a Roth 401(k) are made with after-tax dollars, so you don’t get to deduct the money from that year’s taxes. But don’t worry; the Roth’s payoff comes later.
Pretax contributions make saving a little less painful. Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, which supersizes each dollar you save. Let’s say Uncle Sam normally takes 20 cents of every dollar you earn to cover taxes. Saving $800 a month outside of a 401(k) requires earning $1,000 a month — $800 plus $200 to cover the IRS’ cut. When they — whoever the “they” is in your life — say that you won’t miss the money, this is what they’re referring to. (Here are the contribution limits to shoot for this year.)
Contributions can significantly lower your income taxes. Besides the boost to your savings power, pretax contributions to a traditional 401(k) have another nice side effect: They lower your total taxable income for the year. For example, let’s say you make $65,000 a year and put $19,500 into your 401(k). Instead of paying income taxes on the entire $65,000 you earned, you’ll only owe on $45,500 of your salary. In other words, saving for the future lets you shield $19,500 from taxation.
Investments in the account grow unimpeded by Uncle Sam … Once money is in your 401(k), the force field that protects it from taxation remains in place. This is true for both traditional and Roth 401(k)s. As long as the money remains in the account, you pay no taxes on any investment growth. Not on interest. Not on dividends. Not on any investment gains.
… at least for a while. The tax-repellent properties of the traditional 401(k) don’t last forever. Remember when you got that tax deduction on the money you contributed to the plan? Well, eventually the IRS comes back around to take a cut. In technical terms, your contributions and the investment growth are tax-deferred — put off until you start making withdrawals from the account in retirement. At that point, you’ll owe income taxes to Uncle Sam.
Here’s where the Roth 401(k)’s superpower is revealed.
A Roth 401(k) gets the taxes out of the way, right away. The Roth 401(k) offers the same tax shield on your investments when they are in the account; you owe nothing to the IRS on the money as it grows. But unlike with qualified withdrawals from a regular 401(k), with a Roth you owe the IRS nothing when you start taking distributions.
How’s that, exactly? Remember we mentioned earlier that, depending on the type of 401(k) plan, you get a tax break either when you contribute or when you withdraw money in retirement? Well, the IRS can charge you income taxes only once. With a Roth 401(k), you’ve already paid your due because your contributions were made with post-tax dollars. So when you withdraw money in retirement, you and Uncle Sam are already settled up.