It comes from reader, Sandi, who writes in,

“I just started a new job and in 3 months I’ll have to decide between a regular 401K or a Roth 401K. The employer contributes 5% salary to either. I’d never even heard of a Roth 401K before. What are the major differences? Are there more benefits to one over the other?”

Great question, Sandi!

I believe that the choice between an IRA and 401K is pretty clear cut. However, the choice between a Roth retirement account and a traditional retirement account is always much more subjective.

I’ll discuss what considerations should go into the decision right after covering the basics.

What is a Roth 401K?

Roth 401K’s are relatively new in the world of retirement accounts. They were first introduced in the United States in 2006, but their adoption has been a little slower. According to U.S. News, only 29% of companies in the U.S. have the Roth 401K option. If you do, consider yourself lucky.

A Roth 401K combines many of the benefits of the Roth IRA and the Traditional 401K.

You have the same 401K maximum contribution as a Traditional 401K while still having the tax now/no tax in retirement benefits of a Roth IRA.

Still, there are some important distinctions to be made and a Roth 401K might not be the best for everyone.

Are Roth 401K Matching Contribution Tax Free?

This thought crossed my mind a few years ago when I found out my employer was adding a Roth 401K option: “Wow, I can get post-tax matching contributions to a Roth 401K! More free 401K match dollars!

It’s probably the most common Roth 401K misconception there is.

Unfortunately, Roth 401K matching funds are not post-tax dollars.

When you open a Roth 401K, your employer will open a separate traditional 401K. All matching funds that go into that traditional 401K are pre-taxed, meaning that you are not taxed now, but you are taxed on withdrawals in retirement.

What is the Maximum Employee and Employer Roth 401K Contribution?

Same as the Traditional 401K, the maximum Roth 401K contribution for employees is $17,000 in 2012, or $22,500 for those 50 and over.

The maximum employer contribution for a Roth 401K is also the same as the traditional – $50,000 (combined with employee contribution) or 100% of the employee’s salary.

Roth 401K or Traditional 401K?

Getting back to the original question, there is no right answer on the Roth vs. Traditional 401K question.

Many financial pundits recommend young professionals go with the Roth because they claim you’ll be in a lower tax bracket now than when you are in retirement due to lower earning power now. As such, they argue that it’s to your benefit to get taxed now (Roth) vs. being taxed in retirement (Traditional).

Sounds great in theory, however, I think it’s a flawed argument.

There is an assumption that you will have so much saved for retirement that you’ll actually be earning more income on your retirement account withdrawals than the income you are making right now. That’s not always going to be the case. In fact, for many, the opposite will be true. Painting broad brush statements like that are dangerous.

Others argue that tax rates will only go up in the future, so you might as well pay lower taxes now. This is another dangerous assumption to make. Short-term budget shortfalls may fuel this thought. However, when you look at the historical income tax rate, taxes are lower now than at any point since 1931! The long-term trend has been downward. And with one political party making it their entire platform, that may never change.

Roth 401K vs. Traditional 401K Chart

To understand the differences between the two, it’s often most easily observed through a chart.

As you can see, Roth and Traditional 401K’s are very similar, with the exception of the pre/post tax difference. Unfortunately, only you can answer the question of whether or not you want to be taxed now or in retirement.

It’s a lifestyle choice based on your long-term vision for your finances.

Can’t figure it out? You could always split your contributions between the two!

Roth 401K Discussion:

• Does your employer offer a Roth 401K?
• Do you invest in a Roth 401K over a Traditional 401K or vice versa? Why?

Roth 401K Basics is copyrighted by 20somethingfinance.com without consent to republish.

It’s a great question. And it’s important to get right because there are long-term financial implications.

Usually when people ask me this question, it starts a series of other questions.

So I will do my best to address the original question and some of the other common questions that follow. And I’m curious to see what other questions arise for you.

Roth IRA or 401K?

The quick answer? It depends. When someone asks me this, I immediately follow-up with this question, “What kind of a 401K match does your employer offer?”.

In my 401K match post, I highlighted the following statistics from the National Compensation Survey:

• 49% of employers with 401K plans match 0%
• 41% match a percentage of employee contributions between 0-6% of salary.
• 10% match a percentage of employee contributions at 6% or more of salary.
• The median is a 3% match.

With those statistics in mind, there are two different ways to answer this question:

If your employer matches 0% of your 401K contribution…

Invest in IRA’s first – either a Roth IRA or a Traditional IRA (Roth IRA’s have a buzz about them, but don’t overlook Traditional IRA’s). Max them out. Then invest in your 401K.

Why? You’re not getting a match in your 401K, so there is no benefit to investing in it over an IRA other than the maximum 401K contribution being higher than the maximum IRA contribution. And you’ll have more investment options available to you in the IRA, which can mean lower fees for you. So max out your IRA contribution, THEN invest in your 401K for additional retirement savings and tax benefits.

If your employer matches your 401K contribution…

Invest in the 401K first in order to get the match. That is FREE MONEY that you will not get via IRA contributions. Invest in the 401K until you get the maximum employer match you can possibly get for the year, all the way up to the maximum personal 401K contribution level ($16,500 in 2011) if your employer matches that far. Then invest in your IRA. Once your IRA is maxed out, go back to the 401K.

Roth IRA vs. 401K Conclusion

That’s really as simply as I can answer the IRA vs 401K question.

Keep in mind that the maximum contributions for IRA’s and 401K’s are completely separate and independent of each other. This is not an ‘or’ choice. You can invest in both simultaneously, if you’d like. In fact, I’d encourage you to.

Also contributions to one don’t count against the other. One happens to be with your employer (401K) and the other does not (IRA).

Where Can I Get an IRA?

If you haven’t opened your IRA yet, check out my post on how to start an online broker account. TradeKing and OptionsHouse are two of my favorite online brokers for IRA’s.

Related Posts:

• 10 Free Financial Services
• Zecco Review
• TradeKing Review
• Passive Index Investing

Invest in a Roth IRA or 401K? is copyrighted by 20somethingfinance.com without consent to republish.

I have worked at employers who have matched anywhere from 2% to 7% of salary, and even one that matched in an entirely different way – by percentage of my personal contribution. At the same time, my wife’s employer matches based on an ambiguous end-of-year profit sharing model (which has resulted in a 0% match the past two years). They get an F – in consistency and generosity.

Whatever your employer matches, you should know what the typical 401K match out there is for the following reasons:

1. It can help you compare total compensation, or real wage, when comparing employer offers. Those employers who skimp on your 401K match are likely to skimp in other areas as well.
2. It can signal whether or not your current employer is offering a good match that you should not be overlooking while employed by them.

At the same time, vesting schedules can vary widely and should be considered as well.

So let’s dive into the averages so that you can see where you stand.

Average 401K Match

According to the Bureau of Labor Statistics, the typical or average 401K match, can vary widely. Their 2010 National Compensation Survey, found that of the 61% of employers who offer a 401K plan (a sad statistic in itself):

• 49% of employers with 401K plans match 0%
• 41% match a percentage of employee contributions between 0-6% of salary.
• 10% match a percentage of employee contributions at 6% or more of salary.
• The median is a 3% match.

Well, that’s pretty depressing.

401K Matching Vesting

What paints an even grimmer picture on this data are the vesting schedules. Only 22% of 401K matching vests immediately. Also at 22% are ‘cliff’ vesting schedules. These plans require you to stay with an employer for a minimum number of years, or you don’t get any of the match. And 47% have a ‘graded’ vesting schedule – plans that slowly vest the match with every year of service until you hit 100% (usually at 5 years).

On top of that, 32% of employers don’t even allow you to contribute to the plan unless you’ve been with an employer for a minimum of a year. You heard that right, you don’t have the ‘privilege’ of contributing YOUR money to YOUR retirement until after a year at many employers.

401K Matching Takeaways

Considering that most 401K plans are horrible after looking at this data, pensions are going extinct (if not entirely dead already), and Social Security is in question, it’s really every man/woman for his/herself when it comes to a stable retirement. Here is what I take away from this data.

1. If you get a match, take advantage of it.
2. If you are in the minority who get a match on over 6% of your salary, GET THAT FULL MATCH EVERY YEAR.
3. If you don’t get a match at all, open up and contribute to a Roth IRA or Traditional IRA (I house both with TradeKing). Of course, always get free 401K matching dollars before contributing to an IRA. And you might even want to consider a new employer if you’re not getting a pension.
4. Regardless of match, if you can make the maximum 401K contribution in a given year, do it. The 2012 401K maximum contribution is $16,500.
5. If your 401K fees are high or you don’t have many investment choices, voice your concern to your HR/benefits department in a constructive manner.

401K Match Discussion:

• How does your 401K match ‘match up’? How does the plan work and what is the match?
• How does your employer’s vesting schedule work?

Does your 401K Match Up Against the Averages? is copyrighted by 20somethingfinance.com without consent to republish.

What is a Roth 401K?

It’s essentially a combination of some aspects of a Traditional 401K and a Roth IRA. With a Roth 401K, you can contribute the same contribution amounts as a Traditional 401K, only it is is after-tax dollars (like a Roth IRA). Your contributions and your earnings grow tax-free and are not taxed upon distributions or withdrawal in retirement.

What is the Difference Between a Roth 401K Versus a Traditional 401K?

Roth’s 401K’s  are post-tax, traditional 401K’s are pre-tax. Roth contributions are taxed now, Traditional contributions are taxed in retirement. It’s as simple as that.

What is the 2010 Roth 401K Maximum Contribution?

Much like with Traditional IRA and Roth IRA’s, it is a combined contribution total. The IRS Roth 401K maximum contribution level is the same as the Traditional 401(k) contribution maximum – $17,000 for the 2012 tax year.

Are Roth 401K Matching Funds Also Post Tax?

No! This was the biggest question I had when starting a Roth 401K. I thought to myself, “hmmm… if I contribute to the Roth vs. the Traditional, then my matching funds will be higher because they are in after tax dollars”. Nice try. Your employer’s matching Roth 401K contributions are in pre-tax dollars.

This means that a Traditional 401K will be opened for you by your employer, if you didn’t already have one – and pre-tax matching funds will be placed in it. An employer CANNOT contribute after-tax matching funds to your Roth 401K. Bummer, I know.

What is the Roth 401K Catchup Contribution?

Same as the Traditional 401K. You can contribute an extra $5,500 to your Roth 401K (for a total of $22,000) if age 50 or older.

Can a Roth 401K rollover into a Roth IRA?

Yes, much like a Traditional 401K can rollover into a Traditional IRA (or Roth with taxes paid), you can roll over a Roth 401K to a Roth IRA. And you should probably do this whenever you leave an employer because Roth IRA options from discount brokers like Zecco and TradeKing are usually greater, and with lower fees than 401K plans.

Can you Move Money from a Roth 401K to a Traditional 401K?

No. And you’d never want to. Post-tax funds are always worth more than pre-tax funds.

Roth 401K Contributions Withdrawal Rules

You can withdraw before retirement without tax and penalty if your account is at least 5 years old. There are some exceptions, including disability that would allow you to withdraw early without penalty. And there are some funny rules around earnings to contributions, so check with a CFP on this one if you are considering it.

Roth 401K Discussion

• Does your employer offer the Roth 401K?
• Have you signed up for one?
• If you have the option of a Roth 401K and a Traditional 401K, which are you contributing the most to?

Roth 401K Contibution Maximum Contribution & Comparisons to Traditional 401K is copyrighted by 20somethingfinance.com without consent to republish.

I’ve been hearing a common Roth 401K myth that I’d like to quickly dispel.

It goes something like this:

Why would anyone choose a Traditional 401K over a Roth 401K? After all, your company’s 401K match is equivalent and if it’s post tax with a Roth 401K, you’re really getting more money from your employer. Right?

SORRY!

Your employer’s match on Traditional 401K’s AND Roth 401K’s are both pre-taxed and always automatically put into a separate Traditional 401K account. Your match will be worth the same amount today and in the future, whether you contribute to the Traditional or the Roth. Clever thinking, but not reality.

Roth 401k Match Discussion:

Did you think that by contributing to a Roth 401K you were getting a bigger match?

Related Posts:

• Roth IRA Guide
• Roth 401K Contributions
• 401K Maximum Contributions

The Most Common Roth 401K Misconception is copyrighted by 20somethingfinance.com without consent to republish.

Reasons why I’m contributing to a traditional 401K vs. a Roth 401K:

1. My long-term goal is to retire at an early age, prior to when I would be eligible to start receiving distributions from my 401K (at age 59 and 1/2).
2. Unless you’re a pro athlete, investment banker, doctor, or lawyer (you get the idea) it’s very hard to retire early unless you are investing a decent amount outside of your retirement accounts and starting at a very early age. Saving on taxes now allows me to start saving more earlier than I normally would.
3. Every dollar contributed to a traditional 401K is a dollar taken off the top of your taxable income. For instance, if I earned $40,000 this year and maxed my 401K contributions, my taxable income would be $23,000 versus $40,000. Not only would I be taxed on less income, but I would be pushed into a lower tax bracket, and taxed at a lower tax rate on that income. After doing the math, I would essentially be saving almost $3,300 this year alone.
4. I will be disciplined enough to invest my tax savings in non-tax-sheltered mutual funds to be applied towards an early retirement.
5. So long as circumstance allows, I will be maxing out my 401K contributions, which will result in a nest egg larger than I could ever blow in retirement. In other words, I’m not too worried about my tax bracket in retirement.

The Debate: Roth vs. Traditional

So, a colleague at work and I were debating which strategy was better. His personal strategy is to put 100% of his contributions into a Roth 401K so that he will be taxed less in retirement. His strategy works great if your plan includes working until you are 60 years old, putting more of your after-tax income towards long-term investments, don’t have the discipline to invest your extra tax savings, or you are simply not contributing quite as much towards retirement altogether.

I enjoy financial debate because it allows you to see different perspectives and consider alternatives to your current strategies. Really, there was no winner in this debate because our two strategies were completely different and based more on life philosophy than anything else. However, I wanted to take it to the next level and run some numbers to see what kind of financial shape each of the two paths would take you on.

Traditional 401K vs. Roth 401K, Which Results in More Savings?

First, we’ll need to make some arbitrary assumptions for the sake of a fair comparison:

1. The average annualized rate of return for U.S. stocks was 13.4% from 1926 to 2000. The worst average annual rate of return for U.S. stocks in any 65 consecutive year period has been 8.5%. For this comparison, let’s take the average between the two, and assume both my colleague and I are able to get a 10.95% return on our investments every year in both our retirement and non-retirement investments.
2. We stay employed at the same company, who kindly matches 50% of our total 401K contributions.
3. We are both 23.
4. Our salaries are $40,000 this year.
5. Our annual salaries, and the IRS’s annual 401K contribution limits and tax bracket income limits all increase at a rate of 5% per year over our career.
6. I will contribute the amount that I save in taxes each year (over what he is taxed) to a non-sheltered early retirement account.
7. Additionally, we both contribute 5% of our salaries towards early retirement.
8. The magic amount for retiring early and living off of our interest until we can begin withdrawing retirement distributions (at age 59 and 1/2) is $1 million in non-tax sheltered money. Once we hit this amount, our salary drops to $0 the following year.
9. We also stop contibuting to our non-sheltered accounts in the year following retirement and convert our investments to municipal bonds that return 5% per year, and live off the interest.

Here are the results:

To view the results through a Google Docs spreadsheet:

Trad 401K vs. Roth 401K (Google Docs)

To view the results through an Open Office spreadsheet:

trad-401k-vs-roth-401k.ods (.ods)

Take-aways:

1. I am able to hit the magic retirement amount (column E vs. column H) by age 48, a full 9 years before he does. The extra amount that I was able to invest made a huge difference in allowing my non-retirement savings to grow.
2. We both have a ridiculous amount of retirement income (over $15,000,000) as a result of the power of compound returns because we saved early, saved much, and saved often. Neither of us will be hurting for cash in retirement. Compound returns are you best friend; save early, save much, and save often and you won’t have to worry about your tax bracket in retirement.
3. My total retirement amount ends up being about 10% less, despite stopping contributions a hefty 9 years earlier. Saving early allows you to save less later on. Compound returns again? Yes.
4. My colleague will have much more tax free income in retirement ($11,547,351). Tax free savings have got to be enjoyable.
5. Either way you cut it, when you have financial discipline, save early, and save often, you win.

Which strategy are you implementing?

Related Posts:

• Roth IRA Guide
• IRS 401K Maximum Contribution Limits

Choosing Between a Traditional 401K and a Roth 401K, Part II: How will my Choice Effect Early Retirement? is copyrighted by 20somethingfinance.com without consent to republish.

A growing number of employers are beginning to offer not only a Traditional 401K, but now a Roth 401K as well. If you still don’t know who this ‘Roth’ guy is, or what he does, choosing between the two can be a matter of random guess. At best. This guide will show you how to choose between the two and become an expert amongst your co-workers.

As its name implies, a Roth 401K combines aspects of a Roth IRA and a Traditional 401K. But, before we get into the differences between the two, let’s first find out what they have in common.

Common characteristics between Roth 401K’s and Traditional 401K’s:

• It’s a 401K, which means you must be at work, since you cannot invest in 401K’s on your own. IRA’s, on the other hand, are all on your own.
• The maximum 401K contribution in 2012 to one or both of them combined is $17,000 (add an additional $5,500 if over 50).
• Your employer’s 401K match don’t count towards your annual max of $17,000. They are ‘in addition to’.
• You should always invest to the level of being able to get your employer’s max match before investing in any other retirement vehicle (i.e. Roth IRA, Traditional IRA, annuity, etc.). Why turn down free money? Many employers match half, equal, or even double your contributions. You will never get a 50, 100, or 200% return in the open market on a consistent basis, so don’t turn that down if it’s being handed to you, without risk.
• Your employer’s match on both vehicles is pretax and is automatically put into a Traditional 401K. Sorry, folks, but you will not be given more money in the form of an after tax match from your employer if you are investing in a Roth 401K, so don’t let that be an incentive to choose it over a Traditional.
• You must begin withdrawing funds starting at age 70 and 1/2, unless you are still employed, or you can face penalty.

How Roth 401K’s Differ from Traditional 401K’s:

• A Roth 401K is taxed up front. All of your contributions and earnings are tax free once you reach age 59 and 1/2. Your account must be at least 5 years old at that point, with some exceptions.
• Traditional 401K contributions and earnings are taxed when you start receiving distributions at age 59 and 1/2 in retirement.
• You can withdraw Roth contributions tax and penalty free if your account has been open for 5 or more years. This does not include earnings on contributions. With a Traditional, you cannot withdraw without a 10% penalty, but you can possibly get a loan against from your employer (never do this, please).
• Roth 401K’s can be rolled into a Roth IRA when you leave your employer, tax free. Similarly, Traditional 401K’s can be rolled into a Traditional IRA tax free. If you try to roll a Traditional 401K into a Roth IRA, you must pay income tax on your rollover during the year it is completed.

Other things to note:

• Once your money is in a Roth 401K, it cannot be transferred to a Traditional 401K or Traditional IRA, it can only be rolled over to a Roth IRA at the time of departure from your employer.
• You can put money into both a Roth 401K and Traditional at the same time, which balances out your tax burden both now and when you retire.

Roth or Traditional: Which do I choose? Let’s consider the main 3 arguments:

1. Tax now or tax later? A Roth 401K is designed to be advantageous to a younger employee who may be in a lower tax bracket at their young age, than in retirement (typically, when you get older, your taxable income increases, pushing you into a higher tax bracket). If you’re a younger employee, do you actually care about what you might be taxed in retirement compared to what you are taxed right now? Only your answer to this question matters.

2. Will the Federal income tax rate increase or decrease? Another argument brought up commonly, is that the federal income tax rate could change over time. If you believe it will go up and want to take advantage of lower taxes now, the thought is that you should opt for Roth retirement vehicles versus Traditional. On the flip side, if you believe tax rates will go down, you should avoid taxation now by going with a Traditional retirement vehicle, and taking the lower tax hit when you retire.

Usually, the ones who bring up this debate are the ones who think that taxes will rise over time. So, I decided to do a little research into this. The National Taxpayers Union Foundation, has perhaps the most interesting historical chart I’ve ever seen, which lays out the federal tax rate for the lowest and highest tax brackets since 1913.

What it shows, without bias, is that since the 1960′s, the federal tax rate has stayed essentially identical for those in the lowest tax bracket (about 15%), and has actually decreased significantly for those in the highest bracket from around 70%, to 40% today. Projecting this out another 40 years, you can probably bet on more of the same or perhaps slight increases to the lower tax bracket, but for the higher tax bracket, your guess is as good as mine. If you believe the trend will continue, it will probably be lower. If you believe that will lead to a revolution, expect it to go back up again. Either way, a decision on your 401K investment vehicle should not be made on guesses, so this argument is a wash.

3. What is my long-term financial plan and what are my goals in life?

Perhaps the most important point that nobody discusses when it comes down to choosing between a Roth 401K and Traditional is life philosophy.

Investing in a Traditional 401K allows you to deduct taxes now, which means you have more money to invest, perhaps towards an early retirement. Plugging away in a Roth 401K does not allow you to do this, you will face more taxes throughout your working career in exchange for less taxes later on. So you need to ask yourself: would I rather have more money now to enjoy life and to save for early retirement, or would I rather have more money to live it up in retirement, have extra for medical expenses, and not worry relatively as much about running out of money the further my retirement lasts?

If you don’t have the discipline to invest outside of a retirement account for a possible early retirement, then you may want to consider the Roth so that in the long run, more of your money is invested. If you do have the discipline, and want to have a shot at retiring early, then consider the Traditional. The choice is yours.

Related Posts:

• Choosing Between a Traditional 401K and a Roth 401K, Part II: How will my Choice Effect Early Retirement?

The Complete Guide to Choosing Between a Traditional 401K and Roth 401K is copyrighted by 20somethingfinance.com without consent to republish.