Everything 401(k)

History

The idea behind 401(k) is for employers to offer a mechanism for their employees to save money for retirement in special tax advantaged accounts. 

The name comes from subsection 401(k) of the U.S. Internal Revenue Code.

Basics

The biggest advantage of 401(k) accounts is the employer match. This means the company will contribute to the employee's account (3-6% employer match is pretty standard, capped off at some amount)

For example, say you contribute $500 per pay-check, then the employer will contribute $30 (6%) per pay check capped off at a maximum of $6000

This article will focus on traditional employer offered 401(k) accounts. Note there are other types of 401(k) for self-employed individuals called Solo 401(k) or Self-Employed 401(k)

Types of 401(k)

There are 3 broad types of employer sponsored 401(k) accounts. The first two are very popularly offered by employers whereas the third type (after-tax) is a somewhat uncommon offering

• Regular/Pre-tax 401(k): This is what most people refer to when they say 401(k). This type of account has tax advantages because it is a tax deferred account

What this means is that your contribution is taken out from your paycheck pre-tax and you don't get taxed until you withdraw from the account

• Roth 401(k): This is a  type of account where you contribute money after taxes have been deducted. The big advantage with this is that both your contribution as well as earnings grow tax-free. Yes, you don't need to pay any taxes when you withdraw from this account as long as you satisfy 2 IRS rules :
• You are of age 59.5 years and above
• You have to satisfy the "5 year rule": This rule simply requires that there must be at least five years from your first deposit before you can make a penalty-free withdrawal. So, if you start your Roth 401(k) at 56, you have to wait until you are 61 to withdraw without penalty.

If you don't satisfy either of these rules then you will be subject to a 10% penalty on the amount you withdraw pre-maturely.

• After-Tax 401(k): This is a type of account where you contribute money after taxes have been deducted, however where this differs from a Roth 401(k) is that the earnings are taxed at ordinary income tax rates. 

An advanced strategy with after-tax 401(k) accounts is to roll it over into a Roth IRA or do an in-plan Roth conversion.  This is covered in more details in this advanced strategies post

Which one is best?

This is a tough question because the answer really depends on your overall financial situation and is still hard to answer. The reason being it is hard to predict what your income and tax bracket will be when you retire 15-20-30 years from now. So there is a bit of an educated guess you will need to take. 

My personal opinion is it to have both