There are two different types of 401(k) programs, the traditional 401(k) and the relatively new Roth 401(k).  They have some similarities but also differences. When you are looking to start saving for retirement, you may find that your employer offers both types of plans and may allow you to participate in both.  It is not a pick-one situation. You can actually invest your money in both if your little heart desires.  As of 2010, the maximum amount of you can contribute into your 401(k) plans is $16,500 for people under age 50 and $22,000 for those 50 and above.  Let’s look at the good old fashion Traditional 401(k) before we delve into the new kid on the block.

Traditional 401(k):

Starting Blocks: The 401(k) is a retirement savings program instituted by employers.  It allows the employee to contribute money from their paycheck each pay period into an account which your employer can choose to “match” in full or a percentage, potentially doubling your contribution each pay period. With Traditional 401(k) plans, you are given the option to not be taxed on the contributions until you withdraw later on.  You can, however, be penalized by the IRS if you take the money out before age 59 ½ with very few exceptions.

Saving for retirement is an essential part of life. Don’t bank on a distant unknown relative to leave you a fortune when they die, Mr. Deeds.  It can allow you to live comfortably when you hit the age of retirement, instead of working yourself to the grave (literally).

The Finish Line: A Traditional 401(k) is a great vehicle to help you save for retirement. Generally speaking, the younger work force like to be more aggressive with their long term investing because they obviously have a longer time horizon in front of them. (You most likely won’t need the money in 10 years.)

MATH ALERT!!!!: Dr. C. Good is a 25 year old Optometrist at 2 Eyes who starts saving for retirement from 2013 to 2053 (with a 40-year time horizon). He brings home $40,000 a year doing what he does.  2 Eyes offers him a Traditional 401(k) plan and matches $.50 for every $1 he contributes up to 6% of his yearly salary.  $40,000 x 6%= $2,400, now 2 Eyes contributes $.50 on each $1, so $2,400 x $.50= $1,200. Dr. Good is depositing $3,600 per year into his retirement account, assuming he never gets a raise. Since these are pre-tax dollars he is reducing his taxable income by $2,400 (your employers contributions don’t factor into your income)!  Remember this money will be taxed once it is withdrawn.  He saves $627,600 by the age of 65.

You can also opt to be taxed every time you contribute money to your 401(k); this takes away the tax to be paid when you reach 59 ½ years old.  People might decide to do this because they believe tax rates could be higher in the future.  This method brings us into the new Roth 401(k).

Roth 401(k):

Starting Blocks: With the Roth 401(k) your contributions are with after tax dollars.  This means that you are taxed on the money you contribute to your account unlike the Traditional 401(k). This 401(k) plan is most liked by the government because it turns the tax money into current revenue for the country instead of waiting till you turn age 59 ½ to get revenue.  All your gains are tax free as well if taken out after age 59 ½.  You can also take out your contributions (the after tax money) at anytime with no penalty.  If you want to take out your gains before age 59 ½, you will be charged with a 10% penalty, and if you take out your gains before they have been in the account for 5 years, you get hit with the 10% penalty and taxes! So think long and hard before you decide to take money out early!

The Finish Line: There are many benefits to paying taxes while contributing to your retirement plan.  Some people believe tax rates will increase by the time they retire and would like to pay taxes now, those cautious people.  If you would like to learn more about Roth 401(k) setup an appointment with your personal finance guide.