Saving for retirement at a young age is a good idea. No ifs, ands, or buts about it. Time is the (not so) secret ingredient to successful investing. But where do you begin? What type of 401k retirement plan is the right one for you?
What is a 401k?
Most commonly you’ll hear “401k” when talking about retirement plans. 401k plans are just that – retirement investment accounts. Many employers offer these plans as employee benefits, and some even offer 401k company matching (That’s right, FREE MONEY!… kind of). You’ll invest money automatically in the form of direct deposits, referred to as “contributions” to this account with each paycheck. This money will then be distributed among investment accounts that you choose from a list of available investments.
Different Types of 401k Plans
When it comes to 401k retirement investments, you have a couple different options:
- Traditional 401k
- Roth 401k
The biggest difference between these two investment strategies is when taxes are paid. In a traditional 401k, contributions are made pre-tax. This means the full amount gets invested without any deductions – one of the most attractive aspects of these investments. Not so fast, you didn’t think you’d just get away with this tax free forever, did you? You will have to still pay taxes on this money, but it is paid at the time of withdrawal.
Roth 401k plans are made after tax. This means that when you retire and withdraw the money it is tax-free. The taxes on these investments are paid along the way, deducting from every deposit.
There are also other investment options such as Roth IRAs, which have their own rule, advantages, and drawbacks.
Similarities Between Traditional and Roth 401K Plans
Both 401k types are used for the same purpose – investing for your retirement. Many employers offer both plans as options to their eligible employees. If the employer has a matching program, they will typically match the same regardless of which plan you choose.
Should I Contribute a Set Amount or a Percentage to My 401k?
Many employers offer contribution direct deposits as either a set dollar amount, or a percentage of your paycheck. How you contribute to your 401k is really a matter of personal preference. If you’re paid salary, many people find it easier to contribute a set percentage. This is mostly because company matching programs are often percentage based. However, this could obviously translate to a set amount and contribute just the same.
If you are paid hourly and plan to contribute aggressively, you may want to consider a dollar amount contribution – especially if your hours (and therefore your paycheck) vary week to week. This makes it a little bit easier to budget because you know exactly how much is coming out of your check. However, this somewhat negates the main benefits of percentage 401k contributions:
- You eliminate the opportunity to take advantage of high paying weeks. With a percentage based contribution, you save more on weeks that you’re paid more. Whether this is from a raise, overtime, or picking up additional shifts – you should always save more when you make more.
- You get used to living off less – it’s like the money is never even there. By planning and accounting for a set reduction in your pay, you end up focusing on it. This is another reason that direct deposit saving can be very effective.
401k Contribution Limits
So now you’re probably wondering, “how much can I contribute to a 401k?” According to the IRS the contribution limit to 401k plans has just increased as of 2018 from $18,000 per year to an annual contribution limit of $18,500. And for those over the age of 50, this amount is increased further to a limit of $24,500 per year.
Contributing to your 401k to this extent at a young age is not necessary. Heck, even the fact that you’re considering it and doing some research puts you ahead of most. It’s all about balance. Find a comfortable amount to contribute and increase it when you can – regardless of what that starting amount is, it’ll add up over time.
Which 401k Plan Should I Invest In?
This all sounds great but which is the best retirement investment? That’s simply a matter of personal preference and prediction. Some of the things you need to consider when choosing between a traditional 401k and a Roth 401k:
- You may likely (and hopefully) be in a higher tax bracket when it is time for you to retire, compared to where you’re at now. Therefore, paying taxes now with a Roth 401k could save you some money.
- What will tax rates be like when you retire? You can research and analyze trends to make your best guess, but truly only time will tell.
- What does your company offer? You should always take full advantage of any company matching so long as it doesn’t cripple your personal budget and savings. Some employers will also let you contribute to both types of accounts at the same time, allowing you to enjoy the benefits of both 401k accounts.
Truthfully, any investment is good. And if you start investing at a young age, you can be confident that you’ll have a comfortable retirement. The key is to learn along the way, adjust things when you need to, and increase your contributions when you can.