by Jay P. Nicholls, CFA® | Director of Trading
and
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.
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?
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.