Ways to Save - 401(k) and Roth 401(k)

IRA, 401(k), 403(b) or Roth? Have you heard of them?

These are various types of retirement savings options offered under the U.S. Tax Code. What these plans allow you to do is very important for your financial future—saving for the future is the subject of today’s episode of No-Frills Money Skills.

Last time, I talked about the value of making regular contributions to savings, and starting to save early in life because of the power of compound interest. Remember, compounding is earning interest on your principal and the interest already earned. When students first hear about the magic of compounding they often ask: Where do I save? How can I find the highest return? How much and for how long will I have to save to buy a car, furniture for my apartment or a house…?

These are great questions, but there’s one question that, unfortunately, is often asked way too late: How much do I need to put away for retirement?

With retirement so far off, and all the information available, saving for retirement can feel intimidating, so I’m going to start with some savings basics.

Banks and financial institutions offer many types of accounts. Some of these are easy to open, provide ready access to your money if you need it—what economists call liquidity—and often provide the security of insurance through the FDIC, the Federal Deposit Insurance Corporation.

The most common FDIC-insured accounts are savings and checking. It’s a good idea to have money set aside in a savings or checking account in the event of an emergency—such as a major car repair, a medical expense or an unexpected college textbook. Financial experts recommend that you have as much as six to 12 months of your monthly expenses in savings. There are calculators available online that will help you determine how much is right for you. The point is to have a dollar amount you are comfortable with in savings, and to only use it if you have an unexpected event. Remember, retirement funds are not for emergencies.

So how much should you save for retirement?

The amount of income you’ll need to sustain the lifestyle you want in retirement depends on many factors, including your age, how much debt you have and other features of your lifestyle.

Financial planners generally suggest a saving range of 10 to 20 percent of your take home pay, but each situation is different.

We suggest that you decide on a dollar amount you can afford and commit to depositing it into your retirement account from each check consistently.

Let’s learn some more about different retirement-savings options.

ANNOUNCER: From FRB studios in beautiful downtown St. Louis, it’s time for America’s favorite personal-finance game show. Let’s learn about … Ways to Save, with your host Kris Bertelsen. Kris: So, announcer guy, who are today’s contestants?

Announcer: Well Kris, joining us today from the NuLu district of Louisville, Ky., please welcome David Garrison. Our next contestant hails from Memphis, Tenn. Put your hands together for Peter Ehrhard. And last, but by no means least, from Little Rock, Ark., give it up for Valerie Coleman.

KRIS: Contestants be sure to phrase your answers in form of a question. Let’s get started. Question number one … you can open one these accounts without having your employer set it up.

PETER: What is an IRA?

KRIS: Yes, that’s correct! Now moving on question number two … you can fund this type of account if it is sponsored by your employer.

VALERIE: What is 401(k)?

KRIS: Yes, we also would have accepted 403(b), which is a similar account, but for a non-profit organization. These accounts allow individuals to save some of their income before taxes.

KRIS: Listen carefully to question number three … if you put after-tax income into this account, you will not pay taxes on the income when you take it out at retirement.

DAVID: What is an IRA?

KRIS: Judges? Oh, I’m sorry, that’s not correct. The correct answer is Roth IRAs or Roth 401(k)s. These are retirement accounts setup to allow after-tax deposits. They are named after Senator William Roth, of Delaware, who sponsored the law that created them.

KRIS: Our next question … that sound means we’re out of time.

KRIS: So announcer guy, tell them what they’ve won.

ANNOUNCER: For participating in today’s quiz, each of our contestants will receive a lifetime supply of satisfaction in knowing that their financial future can be brighter, and in addition, they’ve earned the respect and admiration of their peers. Way to go, and thanks for playing Ways to Save!

KRIS: Tax-advantaged savings means that the U.S. Government encourages you—and your employer—to set aside some of your income for retirement, and the laws were written to give tax advantages to people who choose to do it.

If you save pre-tax money in a 401(k) or 403(b), you’ll pay income tax when you start taking it out at retirement.

If you save after-tax money in a Roth account, you’ll pay taxes now, but you will not be taxed on the growth when you take it out at retirement.

Everyone’s financial situation is different, and there are costs and benefits to consider with either scenario.

KRIS: Announcer guy, are you still with us?

ANNOUNCER GUY: Right here, Kris.

KRIS: Show us an example!

ANNOUNCER GUY: You got it! Meet Jaymi, a 22 year-old customer service representative making $28,000 per year.

Jaymi wants to put 10% of her earnings into a retirement plan, but she can’t decide between a regular 401(k) or a Roth 401(k) retirement plan.

We’ll use a typical online calculator to help her decide, and assume an expected annual rate of return of 5%, and an estimated tax rate of 15% throughout our example.

With a regular 401(k) retirement plan, Jaymi can expect a gross balance of $313,938.45 when she retires at age 65, and after adjusting for taxes, she’ll net a whopping $266,847.68.

With a Roth 401(k) retirement plan, Jaymi can expect a similar gross balance of $312,297.45; however, since this type of plan uses after-tax money, there will be no additional taxation at withdrawal.

On the surface this looks like an easy choice to make, but there’s more to consider than just the final balance.

Contributions to regular 401(k) plans are made with pre-tax money, which means that from age 22 through 65, Jaymi would only pay taxes on her salary minus her 401(k) contributions and any other pre-tax deductions she may have, resulting in less tax and higher take-home pay throughout her working years.

On the other hand, contributions to a Roth 401(k) are made with after-tax money, which means more tax and less take-home pay while working; but, as a result, Jaymi will not owe additional tax at retirement, and she can enjoy the full balance of her retirement account.

Another really important factor for Jaymi to consider is what her tax rate might be after retirement.

In our example, we assumed an estimated tax rate of 15%, but what if her tax rate were to increase, and she found herself in a 25% tax bracket in retirement?

With a regular 401(k), Jaymi would save that tax money now by contributing pre-tax money, but will have to pay later—at a rate of 25%—to reflect the tax rate increase.

With a Roth 401(k), Jaymi would pay the 15% on her income now and have no tax obligation on her income from the account in retirement.

So which option should Jaymi choose? The decision is not ours to make. There are costs and benefits to consider with either scenario, and only Jaymi can decide which option is best for her.

Please note that these results are intended for illustrative purposes only, and actual results may vary.

Best of luck, Jaymi! Now back to you, Kris.

KRIS: Our next concept is the employer match. Employers often encourage their workers to save for retirement by offering a match—or matching contribution. That is, employers will match what you’ve saved—up to a certain dollar amount—by making a deposit into your account!

Here’s how it works: if you make $30,000 per year and put 3%, or $900, into a retirement account, your employer will match it by putting another $900 in for you. As you can see, this benefit will do wonders for the amount you can earn in compound interest. Let’s compare your savings over 30 years with and without the employer match to see the difference it makes in your retirement account.

This looks great, but you ask, “What’s the catch?”

Well, before you go to your bank or financial advisor to open an IRA—or ask your boss how to start investing in a company 401(k)—you need to know there are rules about when you can start investing, how much of your income you can invest, and what happens when you take your money out.

We’ll leave the specifics to your employer, financial representative or accountant because the rules vary and depend on the type of plan; however, you have to be 18 years of age to open an IRA.

Well, now you know a little more about Ways to Save. I’m Kris Bertelsen. We’ll see you next time on No-Frills Money Skills.