You just got a great job that pays well and offers the kinds of health benefits that your mom would be happy about. The company refrigerator is fully stocked and your calendar is already peppered with happy hours for the foreseeable future.
Life is pretty good.
Tucked away in a little corner of your benefits package is a 401(k) program, and while you may not pay too much attention to it right now, this one particular benefit holds the key to making sure your life stays pretty good in the future.
What is it?
Simply put, 401(k)s are savings accounts made for your retirement. After you sign up and open a 401(k) account, money is moved directly from your paycheck and put into this account for safekeeping. This money then grows into new money, which will be the money you use after you’ve retired and have started spending your Tuesday evenings at the community bingo hall.
A big caveat before you hunt down your lucky troll doll: you will not be able to touch this money until you are at least 59 ½. There are some exceptions, but generally speaking, you wouldn’t want to touch this money anyway. It’s for retirement, remember?
There are two different ways to contribute money to 401(k)s: a traditional, or pre-tax, way; and a Roth, or post-tax, way.
What’s the difference?
Traditional 401(k)s take your money and put it into your account before deducting any taxes. So if your paycheck is $10,000 (let’s dream big) and you put $1,000 into your 401(k), only $9,000 of that paycheck will be taxed. However, once you begin to take money out (after you’ve retired, of course), that is when the taxes kick in, and the taxes apply to any interest, capital gains, and dividends that your account will have earned.
Roth 401(k)s, on the other hand, tax your money at the moment you put it into the account, just like the rest of your paycheck. Taking our example from earlier, the $1,000 gets taxed along with the rest of the $9,000. However, when you go to take money out, nothing gets taxed, not the amount you put in nor the interest, capital gains, and dividends.
So either way, the government gets its taxes—there’s no escaping that. But 401(k)s give you a bit of flexibility in how you would like to pay those taxes. It’s not often you get a choice in this matter, so you might as well take advantage of it.
What if I just save money on my own?
You can, and probably should. However, the 401(k) offers you something that squirreling your money away in a regular savings account won’t: tax benefits.
Also, many employers will help contribute to your 401(k), but only if you do so first. That’s pretty much the definition of getting free money for your money.
But retirement is so far away, and I still want to backpack through Europe!
You can, and probably should. It doesn’t take much to start a 401(k) account, so you can simultaneously save for retirement and any vacation plans you might have. Just remember that the earlier you start thinking about your retirement savings, the more savings you will have to think about when the time comes.
But I’d have to give up some everyday comforts in order to put money into my 401(k)! Why do you want me to suffer?
It’s true. You may have to give some things up in order to stash money away in your retirement savings: buying lunch everyday, a few drinks at the bar, a movie night here or there. And while I agree that that cup of Philz every morning feels pretty great, take a look at this Small Change, Big Savings tool to see what cutting out one cup of coffee, as well as some other everyday comforts, from your daily routine can do to your savings over time.
Think of it this way: as you’re enjoying your retirement from a beachside resort in Florida, you likely won’t remember the sacrifices you made at some bar 30 years ago, especially not when you’re ponying up to a new one with cash in your hand.
Cash pulled from your 401(k), of course.