“I’ve seen this in my benefits package at work! Did I need to read that section or something?"
You’re likely familiar with this type of defined contribution plan because it’s an employee benefit at many companies, and one of the easiest ways to save for retirement… even if you found this section of your benefits package incomprehensible. The 401(k), named for the IRS code, came around in the 1980s as pensions started declining- so some of you, dear readers, may be as old as the 401(k) itself. Have we got your attention now?
With a 401(k), you can:
- Set a specified amount- either a percentage of your salary or a dollar amount - to be withdrawn from your paycheck and automatically invested into your account. You can always increase or decrease this amount as your circumstances- or salary- changes.
- Choose how you want your money allocated- most employers have a list of mutual funds, target date funds, and money market funds where you can park your cash.
- Contribute up to $18,000 of your pre-tax income; the more you allocate, the more of a cash cushion you’ll have in retirement. Your capital gains and dividends grow tax-free as long as they keep rolling into the plan.
- Get matching contributions from your company (if this is part of your benefits package) up to a certain amount set by the company, usually around 3% of your salary. It’s like getting free cash, so take advantage of this benefit!
- Select a beneficiary for your account- the person who would receive your cash when you die.
Did we mention that your tax rate lowers because 401(k) contributions are taken from your pre-tax income? While you won’t see many of your 401(k)’s benefits until you retire, you’ll see a lower adjusted gross income on your taxes in April, which could put you in a different tax bracket.
Your 401(k) is overseen by a plan administrator, not your company- the administrator is usually a fund family, like Vanguard, Fidelity, or T. Rowe Price, to name a few, and you’ll get quarterly updates on your funds’ performance from them. If you want to change your allocation, you’d contact the plan administrator or visit their website, not your HR department.
More companies are starting to automatically enroll their employees in their 401(k) plans- if you haven’t specifically opted out of this, check with your HR department to see if you’re already enrolled. If you have been automatically enrolled, don’t put your feet up just yet- your company might have set your contributions to a certain minimum, but if you’re able to, consider contributing more.
Though we’re singing the 401(k) gospel, you better not plan on retiring early, because there’s one caveat to your plan - like an IRA, if you make any withdrawals from your account before age 59 ½, that cash is subject to a 10% penalty in addition to regular income taxes. Your company may also have a vesting period before you can withdraw any employer-contributed funds- that is, you can only take out the funds your employer has contributed after you’ve spent a few years with the company.
Now that we’ve discussed your standard 401(k), let’s discuss two other sets of retirement numbers and letters:
403(b): It may have an alias (a tax-sheltered annuity plan, or TSA), but your 403(b) might as well be the fraternal twin of the 401(k). These employer-sponsored plans are usually offered to employees of nonprofits, schools, and other tax-exempt organizations and work almost exactly like a 401(k). Almost. You likely won’t get an employer-match with your 403(b), as most non-profits have, well, no profits to share with you. You also have the option to put your money into annuities as well as mutual funds.
457(b): If you work for the government, an NGO, or university, you might have the option to invest in a 457(b) plan. We’ll call this sister the fraternal triplet of the employer-sponsored family plan. It operates in the same way as your 401(k), and like your 403(b), employers rarely contribute to it. There are two pluses: if your employer offers a 401(k) or 403(b), some offer the 457(b) as a supplemental option, so you can contribute to both accounts. If you retire before age 59 ½, you won’t get hit with that 10% early withdrawal penalty as you would with your other retirement accounts.
Not that any of us plan on retiring soon… but the option is nice.