Traditional 401(k)

A Traditional 401(k) is an employer-sponsored retirement savings plan in the United States, named after a section of the tax code. Think of it as your personal retirement treasure chest, where the government gives you a fantastic deal to encourage you to save for your golden years. The magic of the Traditional 401(k) lies in its tax treatment. You contribute money directly from your paycheck before federal and state taxes are taken out. This immediately lowers your current taxable income, meaning you pay less tax today. Inside the account, your investments can grow year after year without being taxed on dividends or gains—a concept known as tax-deferred growth. The trade-off? You'll pay income tax on the money when you withdraw it in retirement. It's a “pay taxes later” approach, which is often contrasted with its sibling, the Roth 401(k), which follows a “pay taxes now” model. For millions of Americans, the 401(k) is the primary vehicle for building long-term wealth.

The beauty of the Traditional 401(k) is its three-stage lifecycle, each with its own powerful advantage.

When you enroll in your company's 401(k) plan, you decide what percentage of your salary to contribute. This money is whisked away into your retirement account before the taxman gets to calculate your bill. Example: Let's say you earn $60,000 a year and contribute 10% ($6,000) to your Traditional 401(k). The government will only tax you as if you earned $54,000. This instant tax savings is the first perk. Even better, many employers offer an employer matching contribution. For instance, they might match 50% of your contributions up to 6% of your salary. This is, without exaggeration, free money. A core tenet of savvy investing is to never, ever leave free money on the table. Always contribute at least enough to get the full employer match.

Once your money is in the 401(k), you invest it. The real power move here is that all your earnings—dividends, interest, and capital gains—are not taxed annually. They are reinvested and allowed to grow tax-deferred. This unleashes the full, untamed power of compound interest. A dollar earned can be put to work immediately to earn more dollars, without the yearly drag of taxes. Over decades, this tax-deferred growth can lead to a significantly larger nest egg compared to a regular, taxable brokerage account.

The deal you made with the government comes due in retirement. When you start taking money out (typically after age 59 ½), each withdrawal is treated as ordinary income and is taxed at your prevailing income tax rate for that year. If you try to withdraw funds before age 59 ½, you'll generally face a 10% penalty on top of the regular income taxes, so it's best to leave the money untouched. The government also mandates that you start taking money out via Required Minimum Distributions (RMDs) once you reach a certain age (currently 73), ensuring they eventually get their tax revenue.

This is the big question for many savers. The choice hinges on your prediction about your future tax bracket.

• Choose Traditional 401(k) if: You believe you'll be in a lower tax bracket in retirement than you are today. This is common for high earners who expect their income to drop after they stop working. You get the tax break now when your tax rate is high and pay taxes later when your rate is lower.
• Choose Roth 401(k) if: You believe you'll be in a higher tax bracket in retirement. Young investors early in their careers often choose the Roth. They pay taxes now while their income (and tax rate) is relatively low and get to enjoy tax-free withdrawals in retirement when their income and tax bracket might be higher.

Many companies now offer both options, and you can even split your contributions between the two, hedging your bets against future tax uncertainty.

Your 401(k) is not an investment itself; it's the account that holds the investments. Most plans offer a limited menu of options, typically consisting of:

• Mutual funds: Baskets of stocks and bonds managed by a professional.
• Target-date funds: A “set it and forget it” fund that automatically becomes more conservative (shifting from stocks to bonds) as you approach your target retirement date.

From a value investing perspective, the single most important factor to examine here is cost. High fees are the termites of your retirement home, slowly eating away at your returns.

1. Scrutinize expense ratios: This is the annual fee charged by a fund. A difference of 1% might sound small, but over 30 years, it can consume hundreds of thousands of dollars from your final portfolio value.
2. Favor low-cost index funds: If your plan offers them, broad-market index funds (like an S&P 500 fund) are often the best choice. They provide diversification at a rock-bottom cost, a strategy championed by legendary investors like Warren Buffett.
3. Check for an SDBA: Some plans offer a Self-Directed Brokerage Account (SDBA), which opens up a much wider universe of investment choices, including individual stocks and a broader array of funds. This is a great option for sophisticated investors who want more control.

Navigating your 401(k) requires knowing a few rules of the road.

• Contribution Limits: The IRS sets an annual maximum for how much you can contribute. This limit changes periodically, so it's good to check it each year.
• Vesting: While your own contributions are always 100% yours, employer matching funds often come with a vesting schedule. This means you must work for the company for a certain period (e.g., three years) before you have full ownership of the matched money.
• Changing Jobs: When you leave your employer, you have options for your 401(k). You can often leave it where it is, cash it out (a terrible idea due to taxes and penalties), or, most commonly, execute a 401(k) rollover into an IRA (Individual Retirement Account) or your new employer's 401(k) plan. A rollover gives you more control and often access to better, lower-cost investments.