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Decoding the Types of Retirement Accounts: The 401(k)

General

As consumers, we’re constantly bombarded by talking heads on TV mentioning the various types of savings and retirement accounts along with the optimal amount or percentage to which each should be funded. The names and purposes of each can be confusing due to the different features each provides. I’m here to explain the differences. To begin, the account with which most people are familiar is the 401(k), a tax deferred savings account provided by employers. Many employers also offer a contribution match for their 401k plans.

A 401k is the most widely known and widely utilized type of retirement account today. Almost half of Americans have access to such a plan. 401k’s began to be widely used in the 1980’s when companies realized that it was cheaper to fund an employee’s 401k than to pay them a pension, as had traditionally been done. Offering a 401k gives benefits to both the employer and the employee. The largest benefit to the employer is that they receive a tax reduction for the amount paid into the 401k. The benefits to the employee are great, with the largest benefit being that many employers offer a 401k matching program in which the employer matches a portion of the employee’s base pay up to a certain percentage, usually in the 3%-6% range. You should always make sure to contribute at least enough to receive the full match from your employer, otherwise you’re leaving free money on the table.

The tax benefit to contributing to a 401k is that contributions are tax deferred in most accounts. This means that pre-tax money is contributed into the account and taxes aren’t paid until the money is withdrawn. At that point the money is taxed as regular income. Another option which is becoming more popular in 401k’s is the option to fund a Roth 401k. A Roth option is different in that you pay income tax on the contributions you make to the 401k but it grows tax free until you decide to withdraw the money. This is a great option if you expect to pay higher tax rates later in life or if you expect that the government will be raising tax rates. Up to $17,500 can be contributed to a 401k per person per year, unless you’re over 50 in which case you’re allowed an additional catch up contribution of $5,500 which raises the total contribution allowed to $23,000. This contribution doesn’t include the amount contributed by the employer either. 401k’s also offer another possible benefit in that loans can be taken from the account, tax free, for a certain period of time. You’re able to take either 50% of the account value or $50,000, whichever amount is less. This can be useful under extreme circumstances. Under normal circumstances you’re able to begin distributions from a 401k at age 59.5 without any additional penalties. Some 401k’s allow earlier distributions though so it’s necessary to consult the plan documents for each individual plan.

Finally, 401k’s often include a feature which is called vesting. Vesting is simply the amount of employer contributions to which you are entitled. Generally vesting occurs over a 3-5 year time frame with a greater percentage of the employer’s contributions being vested each year. Vesting can come into play if you leave a job prior to being fully vested. You’re always fully vested in the amount of contributions you make into your 401k, however if you leave prior to being fully vested, the part which has yet to vest stays behind while you’re free to roll over both your contributions and the vested amount.

Speaking of rollovers, many people choose to roll their 401k’s into an IRA. This preserves the tax deferred nature of their investments while often providing lower investment costs or a greater number of investment options. Another reason to roll over a 401k into an IRA is that it’s simpler to have an IRA professionally managed. Rollovers can occur at several points throughout life. It’s possible to rollover a 401k after leaving a job, after retirement, and sometimes while you still work at a job using In-Service Distributions. 401k’s don’t have to be rolled into an IRA though, they can also be rolled into another 401k as long as the new 401k allows it.

The 401k plan is an excellent way to save for retirement. Taking advantage of employer contributions is a good choice, otherwise free money is being left on the table. A Roth 401k is a great option as well, particularly for young professionals who expect that their tax rate will increase in the future. Be sure to consider all of your options when creating your personal financial plan.

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