Smart 401(k) Investing—Retirement Savings Overview
Types of Retirement Plans
The salary deferral plan that's available to you will depend on where you work. Publicly and privately held corporations typically offer 401(k) plans. Nonprofit organizations, such as schools and colleges, hospitals and museums, usually offer 403(b) plans, but may offer 401(k)s. Many state and local governments offer 457 plans, and the federal government offers a thrift savings plans.
Some provisions of your 401(k) plan are dictated by ERISA, the federal law that governs qualified retirement plans. For example, plans must cover all eligible employees and treat them equitably. Other details are specific to each individual plan. That’s why, if you move from one job to another, each with a 401(k), some things will seem familiar and others different.
Each plan has a sponsor, usually your employer. The sponsor decides which factors determine your eligibility, what percentage of your salary you can contribute to your plan, whether to match your contributions and which investments will be available within your plan. The plan administrator keeps track of the company’s 401(k), handling management details and making sure that the plan runs smoothly. Your sponsor also chooses your plan provider, typically a financial services company that offers investment products, plan administration and record-keeping services.
Within the guidelines set by the law, 401(k) plans are largely self-directed. You decide how much you would like to contribute to your plan, how you would like to invest—or reinvest—those contributions within the limits of your plan’s investment menu, and eventually how you would like to handle withdrawals from your account.
The federal government caps the amount you can contribute to your account each year. See the Annual Contribution Limits table for current caps, which can change from year to year. You are also responsible for the investment results you achieve, though your employer has the obligation to offer appropriate investment alternatives.
Traditional and Roth 401(k)s
An increasing number of employers are offering employees a relatively new 401(k) choice—a Roth 401(k). Both the traditional 401(k) and Roth 401(k) offer tax advantages when you defer a portion of your salary into an account in your employer’s retirement savings plan. Both feature tax-deferred compounding of contributions that are made to the account. Both have no income limits and require minimum distributions after you turn 70½ in most cases, and both can be rolled over to an IRA when you retire or leave your job for any reason.
But tax treatment between the two 401(k) options differs:
|Traditional 401(k)||Roth 401(k)|
|Contributions||Come from pre-tax income, reducing gross income reported to IRS||Come from taxable income, not reducing gross income reported to IRS|
|Withdrawals||Taxed at your ordinary income tax rate||Tax-free provided account is open at least five years and you are at least 59½|
Employers may offer a Roth 401(k) only if they already offer a traditional 401(k) and may give you the option of splitting your annual contribution between a traditional and Roth 401(k)—though your total contribution can’t be more than the annual limit Congress sets for a 401(k). However, once you’ve made contributions, you may not move money between the two 401(k) accounts because of their different tax structures.
What’s more, if your modified adjusted gross income is too large to allow you to qualify for a Roth IRA, a Roth 401(k) is one way to have access to tax-free withdrawals. There are no income restrictions limiting who can participate. The only requirement is being eligible to participate in your employer’s plan.
Which is right for you?
There is no one-size-fits-all answer. Instead, the right answer for you will depend on your current tax situation and whether your tax rate is likely to be higher or lower in retirement.
Since you don’t pay any taxes on Roth withdrawals, the higher your tax bracket in retirement, the more advantageous a Roth is likely to be. Strong savers—including those who contribute the maximum amount allowed by the IRS each year—are good Roth candidates because they are likely to have a bigger nest egg in retirement that can benefit from Roth’s tax-free withdrawals.
On the other hand, if you’re in a low tax bracket today, you might consider a Roth now, when a lowering of your gross income will not be as significant a tax benefit as it might be later on, if you find yourself in a higher bracket.
Because it comes right out of your paycheck, a Roth contribution is likely to reduce your take home pay by more than a similar contribution to a traditional 401(k), which is made using pre-tax dollars. If you want to save—and take home as much money as possible—a traditional 401(k) is perhaps the way to go. Finally, since no one knows what tax rates will be in the future, diversifying with contributions to both a traditional 401(k) and Roth might be a way to hedge your tax bets with your retirement savings.
403(b) and 457 Plans
Depending on your employer, you might have a different retirement savings plan. These plans share the same basic structure as 401(k)s: pretax contributions and tax-deferred earnings. The contribution limits are also the same. And the money you accumulate in one type of plan may be moved into any of the others (provided the new plan permits transfers). But these plans also have features that set them apart from 401(k)s.
Nonprofit organizations, educational institutions, religious institutions and certain hospitals may offer 403(b) plans, also known as tax-sheltered annuities (TSAs) or tax-deferred annuities (TDAs). In a 403(b) your investment menu is limited to annuities—fixed or variable and in some cases equity-indexed annuities (EIAs)—or mutual funds. Your employer may choose to match your contributions, but that practice is less common than with 401(k)s. But if there is a match, you usually have immediate vesting, or the legal right to all contributions and their earnings. That differs from 401(k) plans, where it might take up to six years to fully vest.
State and local governments typically offer 457 plans, also called deferred compensation plans. Rather than belonging to you, your assets are held in trust for the duration of your employment. Not all of the same rules for early withdrawal penalties and required minimum distributions that apply to 401(k)s apply to 457s. And while you can use the same guidelines for catch-up contributions as apply to the other plans, 457s have a catch-up system of their own.
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