Money Rehab with Nicole Lapin - Who Wins: Roth 401k versus Traditional 401k?

Episode Date: September 7, 2021

If you’re deciding which 401k is the right fit, this episode is for you. Learn more about your ad-choices at https://www.iheartpodcastnetwork.comSee omnystudio.com/listener for privacy information.

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money is working as hard as you do. So why overcomplicate your money? Keep it simple with Bank of America, your one-stop shop for everything you need today and the goals you're working toward tomorrow. To get started, visit bofa.com slash newprosmedia. That's b-o-f-a dot com slash n-e-w pros p-r-o-s media. bfa.com slash newprosmedia. Hey guys, are you ready for some money rehab? Wall Street has been completely upended by an unlikely player, GameStop. And should I have a 401k? You don't do it? No, I never do it. You think the whole world revolves around you and your money.

Well, it doesn't. Charge for wasting our time. I will take a check. Like an old school check. You recognize her from anchoring on CNN, CNBC, and Bloomberg. The only financial expert you don't need a dictionary to understand. Nicole Lappin. Setting yourself up for retirement is one of the best money moves you can make

and one of the smartest things you can do to look out for your future self. We know this. But when it comes to actually doing the dirty work of setting up those retirement accounts, the answers aren't so obvious. There are many different options and funds and acronyms in the alphabet soup that is retirement accounts. Today, we're answering a question from listener Anika about two of these options. Hey, Nicole, my name's Anika. I recently got a promotion at my job, which now includes benefits. I'm currently trying to decide between a Roth 401k and a traditional 401k, and I would

love to understand the difference between the two and what one is a better option. I already do invest in a Roth IRA, but I was hoping to learn more about the 401k version of that. So if you could help me understand this, I would appreciate it. Thanks so much. First of all, Annika, congrats on the promotion. That's awesome. I hope you've taken a beat to step back and celebrate your hard work. So cheers to you. And if you are doing a little toast for yourself, pour a little extra sip for me, please. And thank you.

In my humble opinion, your company should have been paying your benefits from the jump, but better late than never. Getting options from your company should have been paying your benefits from the jump, but better late than never. Getting options from your company is great. We love options, but it can also be a little overwhelming. So let's break it down. A traditional 401k is a retirement account that's tied to the stock market. The account is established by employers for employees. If you're at a company that offers a traditional 401k, any money you contribute goes into your account before taxes. Essentially, you're making contributions before your paycheck hits your bank account, and then your 401k contribution is invested in an account

with your name on it. However, do not think that this money is tax-free because you do pay tax when you take that money out. In other words, the money in your 401k grows tax-deferred, meaning you still have to pay taxes on that amount you contribute, plus all of the money you earn in that account later on. Compared to other retirement plan options, the contribution limit with 401ks are higher, which we like. The personal contribution limit for 401ks in 2021 is $19,500. That is much better than, say, an IRA, where the maximum amount you contribute annually is six grand if you're under 50 years old. If you take it out before you're 59 and a half, yes, that is really the number the IRS

came up with, you have to pay penalty fees. Now let's let Roth 401ks enter the chat. This account is just like a traditional 401k with one key distinction. You pay taxes on that money now. You may be thinking, wait a minute, Lappin, why do you want me to pay more taxes now? Well, with a traditional 401k, you have no idea how much the tax rate is going to be when you retire. And taxes don't have the habit of going down. On top of that, you will have to pay taxes on the money you earn in that account. But with a Roth 401k, you've already paid your taxes. When you go to take that money out of your account, the money you have is the money you get. No more taxes. Plus, your tax bracket will likely be higher in the

future because you'll be a badass money rehab graduate, of course, making big buckaroonies. Therefore, paying taxes now when you're in a lower tax bracket will benefit your future self. Anika, you are super lucky that that option is available to you. Given the choice between a traditional 401k and a Roth 401k, I highly, highly recommend that you opt for the Roth. Oftentimes, people with traditional 401ks think they have a huge amount in their account, but they don't realize that in some cases, that nest egg can be eviscerated by taxes when they want to take that money out. We don't know what taxes are going to look like in the next three years, much less 30 years. So with a traditional 401k, we actually don't know

how much will be left over for our old lady selves to spend. A huge perk of both traditional and Roth 401ks is that sometimes your employer can make a matching contribution to your account, which is like getting free money. Anika, I'd be sure to ask your boss whether your company is doing any sort of matching program. With a traditional 401k, employer matching is quite straightforward. With Roth 401ks, it's a little funky. With Roth 401ks, even though you pay taxes on your contributions when it goes into the account, your employer is matching with pre-tax dollars. So their matching funds will be put into a traditional 401k. Capisce? I'd take a little extra time to talk to your employer, though,

if you're still confused about how this works at your company. I'll leave you with a word of caution on 401ks in general. 401ks aren't and were never intended to replace your income when you retire. It's just how we started using them once traditional pensions, which were meant to replace your income when you retire, started becoming way less common. Pensions would guarantee you money when you retired, and that put the burden on your employer to make sure that money was there when you needed it. employer to make sure that money was there when you needed it. Nowadays, 401ks are cheaper for employers to run because they put the burden on you. Most people don't realize that 401ks aren't actually meant to be your only retirement account. They are actually technically profit-sharing

accounts because they allow you to have 100% of your money in the company's stock, which you should never do. Hello, Teco, WorldCom, Enron, anyone? Maybe it's just me, but the basic idea of having your retirement and your job being so closely linked seems wrong. After all, familiarity might breed contempt in family, but it breeds blindness in business. If you put all your money in your company's stock and the company goes out of business, your livelihood is doubly screwed. Now, with losing your job, and later, with losing your retirement savings. This is why I was so excited to hear that you're also using a Roth IRA, Annika. These days, I recommend money rehabbers have more than one retirement account going. When it comes

to building your best Betty White life, the more retirement accounts, the merrier. And if those accounts are Roths, the merrier-er. For today's tip, you can take straight to the bank. If you're deciding how much to contribute to your 401k, first look at your emergency fund. You need six to nine months of emergency reserves in the bank. If you don't have a cushy emergency fund, consider putting more of your endgame allocation into your emergency fund before your 401k. Yes, you need to save for retirement, but you need liquidity first. Unfortunately, if your car breaks down, you can't pay for repairs with a 401k.

Money Rehab is a production of iHeartMedia. I'm your host, Nicole Lappin. Our producers are Morgan Lavoie and Catherine Law. Money Rehab is edited and engineered by Brandon Dickert with help from Josh Fisher. Executive producers are Mangesh Hatikader and Will Pearson. Huge thanks to the OG Money Rehab supervising producer, Michelle Lanz, for her pre-production and development work. And as always, thanks to you for finally investing in yourself so that you can get it together and get it all.