So one of our readers asked us this question the other day: What is a 401k?

ANSWER

A 401k is a special savings account with three rules:

1. You pay much less tax on what goes into a 401k (and, if you want, don’t have to pay any tax at all on it until you take the money out).

2. You can only put up to $18,000/year into the account.

3. You can’t take the money out until you turn 59.5 years old (you actually can, but you pay a penalty that totally removes the value in putting the money there in the first place).

The program was created by the US federal government to incentive people to save for retirement. Typically you pay a percentage of each paycheck into your 401k, and most employers will match what you put in up to a certain percentage (usually 2-6% of your paycheck). Employers do this as a benefit; whatever percent they match can effectively be seen as a raise, which is pretty nice. You should start saving in 401K as young as you can do so reasonably. The earlier you start saving the more you’ll have for retirement.

401k plans come in two flavors:

1. Traditional 401k plan contributions reduce your taxable income. This is known as tax deferral – you are not taxed on the money you contribute now, but will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your 401k in the future.

2. If you contribute to a Roth 401k, contributions have already been taxed at your current marginal income tax rate. In exchange, all earnings may be distributed tax free if the distribution meets certain age and eligibility requirements. Note that not all 401k plans have a Roth option.

Which one do you choose? It depends on a lot of factors, but the big ones are:

1. Income – High earners are usually better off contributing to a traditional 401k, as this allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes usually favor the Roth option, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again.

2. Your guess about your future income tax rates – Those that believe they will be in a lower income tax bracket when they retire usually favor the traditional 401k. Those that believe they will be in a higher income tax bracket when they retire usually favor the Roth option. Those that believe income tax rates will rise across the board in the future usually favor the Roth option.

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Last Update: July 9, 2016

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