In our last post, we explored what saving for retirement actually is and why despite being young professionals, we actually need to do it. Now, I’d like to tackle another big topic in retirement, the 2 main types of retirement accounts: Roth and Traditional 401(k).

Quick point of clarity: 401(k) retirement refers to an employee sponsored retirement plan. Your employer takes money out of each paycheck and deposits it into your retirement account with a company like Fidelity/Vanguard. As of recent, many plans allow you to contribute into a Roth account or a Traditional 401(k). An IRA (individual retirement account) is something completely different, its an account that you manage on your own and only has the Roth option. I’ll only discuss the 401(k) plans, but the discussions for Roth 401(k)s also hold true for IRAs.

Traditional 401(k)

The fundamental difference is that this plan allows you to contribute to your retirement tax-free. Your money goes straight to retirement and doesn’t get taxed.

1) Pay no taxes on your money now

2) Lowers your taxable income

3) Can withdrawal at 59.5 years old, must start withdrawing at 70.5 years of age.

4) Can contribute $17,500 per year (effective 2013)

A big benefit is the employer contribution. Many employers will (tax free) match your contributions up to a certain percentage (often up to 2-8% of your salary). You have to be foolish not to contribute at least up to this amount because it’s “free money”.

When you start to withdrawal your money upon retiring, that’s when your money gets taxed.

Roth

With this plan, you pay taxes on your contributions and then your money goes into your retirement account. The beauty of this plan is that once you pay your taxes on this money, it grows until you withdrawal it tax-free!

1) Pay tax now

2) Watch your money grow (hopefully!) and pay no tax later

3) Can withdrawal at 59.5, but don’t necessarily have to withdrawal later on (vs. Traditional where you are forced to; the government wants their share!)

4) Can contribute $5500 per year (effective 2013) to a Roth IRA, but can contribute $17,500 to a Roth 401(k).

Which one should I choose?

It’s a fiercely debated topic. People on the Roth side point to the fact that although they don’t know what taxes will be like when they retire, they are pretty sure taxes will be much higher. Roth(ers) would rather pay tax now and be done with it. Traditional(ists) enjoy the decreased tax liability that a traditional plan offers.

I’m not qualified enough to actually point you towards one plan, nor even if I was could I say with certainty which is best. For me personally, I like to hedge my bets; I contribute about 60% to a Roth plan, and about 40% of my retirement to a Traditional Plan.

Why does the government even offer such tax benefits?

The government realized early on that they could not be solely responsible for people upon retirement and they saw the value in people actually being self-sufficient in retirement. To be self-sufficient in retirement, it takes financial discipline from an early age, and to encourage that behavior, the government offers tax incentives.

How much should I be saving?

At the bare minimum, save up to the amount your employer will match. Otherwise, you’re just throwing money away. A good bet is 10-15% of your income. Saving an amount like that over your working career, and assuming the market doesn’t crash (fingers crossed), we should all be millionaires upon retiring (assuming healthy, but standard returns). That’s pretty sweet.

Interested in learning more…like a lot more? Check out the YMF guide on “Saving for Retirement” and get step-by-step guidance on how to set it up and everything you need to know to get you started and on your way!