Roth vs Trad 401(k)

There are two kinds of employer sponsored defined contribution retirement accounts: the Roth and traditional 401(k). These two options are analogous to the Roth and Traditional IRA accounts:

• With a Roth 401(k), taxes are paid on the contribution, and withdrawals in retirement are tax free.
• With a traditional 401(k), contributions are not taxed, but withdrawals in retirement are.

In Money Magazine, Walter Updegrave compares the two types of accounts:

Investing $11,625 in after-tax dollars in the Roth 401(k) is the equivalent of making the maximum $15,500 contribution of pre-tax dollars into a regular IRA. But you’re not limited to contributing $11,625 in after-tax dollars to the Roth.

…

Which means that as long as the dollar amount you can contribute to a regular 401(k) and a Roth 401(k) are the same, the Roth 401(k) effectively gives you the chance to sock away more money on a tax-advantaged basis for retirement, assuming you’re willing to part with the extra bucks. [emphasis added]

At my new job, I have the option of opening a retirement account of either type. Last summer I worked out my budget assuming that I would open a traditional IRA (because I did not know the Roth was an option). The immediate benefit of the traditional 401(k) is the tax savings, leaving more money in my pocket each month.

But since a Roth 401(k) is available and it allows me to ultimately save more money for retirement, I am going with a Roth. That makes my take home pay a bit smaller, but in the long run I will appreciate having more money in retirement.

Guaranteed Returns

This week I am writing about conversations I had with my extended family about finances. Today, I turn to a conversation with my father.

Since my father retired and rolled over his 401(k), my parents were considering hiring a financial advisor. Fidelity offered an advisor for 1% of assets under management. This 1% would be in addition to fees charged in mutual funds.

Instead of hiring someone else, I suggested that I could help my parents to manage their retirement funds. My dad wanted me to guarantee him a rate of return. I said that I could only guarantee a weighted average of major market indices. He chuckled and said ok.

Weighted Averages

The Dow Jones Industrial Average (DJIA) and the S&P 500 are two of the best known indices in the US. Each of these is a “basket” of stocks that represent part of the stock market. The DJIA consists of 30 large companies, such as American Express, Coca-Cola, HP, and Wal-Mart and Walt Disney; the list is maintained by the editors of the Wall Street Journal and “for the sake of continuity, composition changes are rare.” The S&P 500 consists of 500 large companies that are financially viable and represent a range of industries (see the criteria for inclusion here).

There are many other indices that track specific sectors (i.e., technology, energy, pharmaceutical, real estate) or parts of the world (China, Europe, …). Investment firms Fidelity and Vanguard offer mutual funds that track indices.

By investing in funds that track major indices, you can expect returns that are a weighted average of internaional market returns.

p. s.

We worked out a nice deal — Since I am helping my parents manage their money and my brother is not doing anything, he has to give them money if they run out. (It is a joke, and my brother laughed when he heard it.)

This is my mom’s perspective on my financial advice.