What is a 401(k)?
A 401(k) plan is an employer-sponsored, tax-advantaged retirement account that companies can set up for their workers. Not only do employers set up these accounts, they often offer an "employer match" as an added benefit -- that is, they will match the funds you add to your 401(k), up to a certain percentage of your salary. Many employers typically cap their match at about 3% of a worker's salary, but that seems to be rising; the average is now close to 5%.2
Once you set up a 401(k) plan through your employer, it's easy to make contributions because they come directly from automated payroll deductions. This means you don't have to worry about choosing how often to put money into your 401(k) or how much money to put in each time you make a contribution. Instead, you set up a recurring deduction through your employer's plan and the rest happens for you automatically with each paycheck.
Just like IRAs come in two different flavors, 401(k) plans do as well. The two types of plans are traditional and Roth 401(k)s.
How do traditional and Roth 401(k)s differ?
Traditional and Roth 401(k)s come with the same contribution limits ($19,500 for 2020)3 and similar (though not identical) withdrawal rules. The main difference is in how the tax advantages for each work.
Traditional 401(k)s: When you put money into a traditional 401(k), it's considered pretax income. It lowers your taxable income in the current year -- but the distributions you take from the account once you retire become part of your taxable income in that year. The main withdrawal limitation around the traditional 401(k) is that you need to be at least 59 before you can access your money without penalty.
Roth 401(k)s: If you fund a Roth 401(k), on the other hand, the money you contribute is post-tax. That means the money you put into your Roth 401(k) counts as taxable income for the current year. However, when you withdraw your money from the Roth 401(k) in retirement, you get to do so tax-free, since there are no taxes on qualified distributions. With a Roth 401(k), you need to be 59 to take distributions -- but the account must also be at least five years old.
What type of 401(k) plan is right for you?
Not all 401(k) plans offer a Roth option -- but if you have a 401(k) that allows you to choose, which should you use? It all depends on your financial situation, your goals, and your tax bracket.
If you prefer to pay taxes now so that your contributions can grow tax-free and you can make tax-free withdrawals in retirement, contributing to the Roth portion of your 401(k) may make sense. You might want to do this if you think your tax rate will be higher when you retire than it is today.
However, if you want to lock in a tax savings today -- or if you need the current tax break to be able to contribute the maximum to your 401(k) to secure the matching funds -- a traditional 401(k) might be the better way to go. As an additional perk, reducing your taxable income today may push you into a lower tax bracket. Just keep in mind you'll eventually pay taxes on both income and earnings when you withdraw the money in retirement.
Either way, it's important to check with your tax advisor to find out how your participation in your 401(k) plan could affect your personal tax situation.
If it feels a little overwhelming to run the math on the different options, check out this traditional vs Roth 401(k) calculator to see which option allows you to build a bigger nest egg over time.
Can you contribute to both a traditional and a Roth 401(k)?
What if you'd rather split the difference and put a little money in each bucket? That might be an option. If your 401(k) has a Roth option, you may be able to contribute to both that portion of the plan and the traditional portion at the same time -- but the sum of your annual contributions can't exceed $19,500 in total.
Not all 401(k) plans allow you to split your savings between the two different types of account, so check your plan document to see what the rules are.
How do you open a 401(k) plan?
401(k)s are only available if your employer offers them as an employee benefit. If you want to open a 401(k), you need to talk to your HR department -- or ask your direct supervisor if your company doesn't have dedicated human resources staff.
You also need to decide how much you want your employer to withhold for your retirement account each pay period. Be sure to ask about the employer match and the vesting period4 (if any). If you can, contribute at least enough to get the full match available; otherwise, you leave free money on the table.
What happens when you leave your job?
When you eventually leave your current employer, you'll have a few options of what to do with your old 401(k). Some employers will let you keep your account where it is, but if your balance is $5,000 or less you may be required to move it to a different platform even if your employer generally allows former employees to keep their 401(k)s. If you want or need to move the funds, options will include rolling the money over into a 401(k) plan with a new employer or rolling it over into an IRA.
Whatever you choose, it's important to note what's in a traditional 401(k) and what's in a Roth 401(k). Because of the differences in how each type of plan is taxed, you'll need to roll traditional 401(k) funds into another traditional 401(k) or into a traditional IRA, while Roth 401(k) funds will need to be rolled over into another Roth 401(k) or into a Roth IRA.
If you need help with your decision, a financial advisor can provide additional guidance. Questions? Give us a call at 1-888-SYNOVUS (1-888-796-6887).