Traditional vs. Roth
Most employer sponsored plans allow you to contribute to the plan on a pre-tax basis (Traditional 401(k)) or an after-tax basis (Roth 401(k)). Determining which option is best for you can be a difficult question to answer. There are advantages and disadvantages to each option.
The Traditional 401(k) reduces your taxable income effectively lowering the amount of taxes you pay today. That money will grow tax-deferred inside of your 401(k) account until you withdraw it in retirement. When you begin withdrawing that money in retirement, the IRS requires you to pay federal and state income tax on that money. In addition, once you reach age 70.5, you must begin taking Required Minimum Distributions based on your actuarial life.
You also have the option of contributing to the Roth 401(k) with after-tax dollars, meaning that you do not receive a current tax deduction. The benefit of the Roth 401(k) is that those dollars grow tax-free and withdrawals in retirement aren’t taxed. In addition, the IRS does not require you to make withdrawals at age 70.5.
Keep in mind that you have the ability to contribute to the Traditional and Roth 401(k)s together, it is not an either-or decision. Furthermore, unlike IRAs, there are no income limits inside of a 401(k) that would prohibit you from contributing to either option.
Starting early/compound growth
The sooner you start contributing to your company’s 401(k), the better. The reason being is that you are putting your money to work at an earlier age. By increasing the amount of time your money is compounding, you can accumulate significantly more at retirement. Here is an example that illustrates the benefits of starting early.
Let’s assume that three individuals, age 25, 35, and 45, made an annual investment of $6,500 until the age of 65. As you can see, our 25-year-old investor has an incredible advantage over the others, with a final value of $803,034. The 35-year-old achieves a final value of $441,662. The 45-year-old has a final value of $219,811. Remember that no matter how old you are, starting today is better than waiting to invest. It’s never too early or too late to start saving for retirement.
*This chart shows an annual investment of $6,500 from the ages of 25, 35 and 45 until the age of 65. It assumes a steady return of 5%. This chart is for illustrative purposes only and is not meant to portray actual investments. There is no guarantee the results shown will be achieved or maintained over any period.
Increasing contributions every year
Not only does compound earnings make an impact but small increases to your monthly contributions will add up over time. You can do this by increasing the percentage of your salary that you contribute to your plan. Increasing your contribution by as little as 2% may result in a bigger account balance and more financial security at retirement.
Let’s look at the examples below based on a salary of $30,000 and an average annual return of 5% for 10 years. The bar on the left shows a contribution of 3% of $30,000, which results in a balance of almost $12,000 at the end of the 10 years. On the right, the contribution has been increased to 5%. You can see how this contributor ended up with more than $19,000 — a big difference when the contribution rate was increased by only two percent. As you can see, just by increasing your contribution rate by 2% – from 3% to 5% – you can increase your overall balance. In this example, by a difference of $7,750. That’s almost $8,000 more to put toward your retirement savings just by increasing your contribution rate by 2%.
*The calculation does not assume any mortality, disability, withdrawal or salary increase. Example assumes a consistent salary of $30,000 and an annual return of 5% compounded monthly. Example is hypothetical and for illustrative purposes only. Investment returns cannot be guaranteed.
Maximizing the Company Match
Some companies will match all or a portion of your contributions to the 401(k) plan. This is essentially free money and all you have to do to receive the free money is to participate in the 401(k) plan. Take a look and see if your company offers a match on your contributions and be sure to at least contribute to maximize the free money that your company offers.
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