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401(k) And Roth 401(k)
Want to retire with dignity and not have to rely on spam sandwiches and off-brand prune juice? Retirement savings are pretty much a must.
If you work in the good ol' U.S. of A. in a typical job, part of your hard-earned cash is going towards Social Security, which is supposed to give you some moolah for when you retire. The problem: it's not really enough for most folks who get used to the idea of things like decent food and hot water. That's why retirement accounts were created: so that you can put even more of your hard-earned money away to pay for retirement.
The most popular type of retirement accounts are the 401k and Roth 401k.
- The Roth 401k was created back in 1978. It's a "qualified" plan, meaning that you don’t automatically get it just for showing up. Instead, you and the company you work for are going to have to sign a bunch of papers and properly structure the thing.
- The 401k is a "defined contribution plan," meaning that the money put in by the employer and worker are defined. It is not a "defined benefit plan" where your boss would be on the hook for investment return minimums.
A lot of people choose 401k because most employers will match contributions. For every buck you put in, your employer may give you another buck—until you retire. It's like a twofer on your investing dollar before you even start investing the dough, and it's probably the closest you're going to get to free money from your boss.
401k vs. Roth 401k
So what's the difference between a 401k and a Roth 401k?
With a 401k, you get your retirement account from your boss, and the money you put in gets taken out of your paycheck before you pay income taxes. Let's say that you make $40,000 a year and invest $5,000 in your 401k. Instead of being taxed on $40,000 you're taxed on $35,000, like that $5,000 never happened. Presto—a lower tax bill. But (of course there's a but), while you don't pay the taxes now, when you retire, you're taxed on the money you take out of the 401k, so the IRS won't be sobbing into their pillow at night. Like Vegas, the house always wins.
With a Roth 401k, you can set up your account with a bank or financial advisor, so it's an option if your boss doesn't offer retirement benefits. The Roth 401k also doesn't give you any tax advantages now. If you make $40,000 this year and contribute $5,000, you still pay income taxes on $40,000. Sorry. But when you're a golden oldie and ready to invest in salsa classes, you can take money out of your Roth 401k without having to worry about paying taxes then. So more cash for you when you're grey.