| wealth management  by Jay P. Nicholls, CFA® | Director of Trading

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 | wealth management by Katie E. Exchange, CFP® | Associate Wealth Manager

Boston Financial Management’s Financial Life 101 Series is designed for the next generation of investors. Our goal is to empower and educate, so everyone, from novices to experts, can find the peace of mind that comes from understanding their financial options. Please share this commentary with anyone you believe will benefit from its content.

If your employer’s benefits package includes a 401(k), you should seize the opportunity. 401(k)s are a great way to save for retirement and offer many advantages, such as multiple investment choices and tax-free growth of your investments. Many companies also offer employer matching of your 401(k), meaning the employer contributes a certain amount or percentage to your savings plan, based on your annual contribution. The best benefit is the power of having your investment contributions compound over time. When you earn interest on investments, through the years that interest earns interest on itself. This process repeats, and the sooner you get started, the more your money can grow. A simple example may surprise you. If you save $20,500 a year in a savings account earning 0%, over 35 years, you would have $717,500 saved. If you invest that money in a combination of high quality stocks and bonds, earning an average of 7% per year, it would grow to over $3 million. The chart below illustrates the difference between just a contribution, and a contribution generating interest, dividends and capital appreciation. Your investments can continue to grow long into retirement, as well.

 | wealth management

Now that you understand how powerful compounding can be, the next step is determining which type of retirement account to invest in, a Traditional 401(k) or a Roth 401(k). Let’s explore those differences.

Traditional 401(k)

This is the option that may be familiar to most investors. With a Traditional 401(k), an employee can elect to automatically defer pre-tax money from his or her paycheck into a 401(k) (up to a maximum of $20,500 for 2022 and a catch-up contribution of $6,500 if you are over the age of 50). The amount of your salary deferral will be excludable as taxable income in the current tax year and thus lower your tax bill. The money can be automatically invested how you choose and grow tax-free in the 401(k) until retirement. You will not have any tax consequences until you start to withdraw money during retirement, at which time distributions will be taxed at your ordinary income-tax rate. The benefits of the Traditional 401(k) contribution are the immediate reduction in your income tax liability as well as the tax-free compounded growth of the assets.

Roth 401(k)

A Roth 401(k) will allow you to defer the same amount into your 401(k) as a Traditional 401(k), however, it will use post-tax dollars. This means that you will pay income tax on the contribution in the year it is made. Like a Traditional 401(k), the investments grow tax-free. Unlike the Traditional option, distributions in retirement will be income tax-free. Rather than reducing your current income tax liability like the Traditional 401(k), Roth 401(k) contributions are in essence prepaying the taxes on any growth in the account and reducing your future income tax liability.

 

Which one is right for me?

That depends on your current situation and view of the future.  When deciding between a Traditional or Roth 401(k) contribution, consider your current income and the level at which it is taxed. If you are currently in a lower income tax bracket and anticipate being in a higher bracket during retirement, the Roth 401(k) contribution may make more sense.  Time is another factor you will want to consider. The longer the time horizon you have for contributions to be invested and enjoy tax-sheltered growth before retirement, the more appealing it is to pay the income tax on the contributions now. This can provide you with the luxury to withdraw the growth on those contributions tax-free throughout your retirement years. As we always advise, please consult with your tax preparer before making any decisions.
 
The reality is many people are not sure what the future will look like, but luckily many plans allow the employee to split their contributions between both types of 401(k)s. Your contributions can be invested similarly, so you can prepare for either scenario in retirement. Keep in mind, these options are not set in stone and you can make changes as your situation evolves. It is a good idea to do a self-checkup annually to ensure you are getting the most out of your financial plan.

The team at Boston Financial Management is always available for retirement planning questions. Please do not hesitate to contact your Wealth Manager directly or call our main line at 617-338-8108 and someone from our team of specialists will be happy to speak with you. If you enjoyed this article, and have other topics to suggest, let us know.

Important: This alert does not contain any legal or tax advice. You should always consult with your attorney, accountant, or other professional advisors before changing or implementing any tax, investment, or estate planning strategy.
 
IRS Circular 230 Disclosure: Pursuant to IRS Regulations, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
 
Professional Designation Minimum Requirements Disclosures:
 
CFA® – Chartered Financial Analyst. Minimum requirements for the CFA® designation include an undergraduate degree and four years of professional experience involving investment decision-making, in addition to successful completion of each of the three CFA level examinations. 
 
CFP® – CERTIFIED FINANCIAL PLANNER™. Minimum requirements for the CFP® designation include a bachelor’s degree from an accredited college or university, completion of the CFP Board’s coursework, 4,000 hours of qualified experience, and successful completion of the CFP examination, which consists of 170 multiple choice questions. 30 hours of continuing education is required every two years.