Block by block start building your nest egg. But first, what is the difference between the various retirement plans.
What is a 401(k)?
A 401k is a retirement plan sponsored by an employer. This plan permits employees to make contributions from their salary to the plan before taxes or on a Roth basis. The employee chooses how to invest the funds. The investments and earnings grow tax-free. For 2020 the maximum contribution is $19,500 with a $6,500 catch up if you are over 50.
The benefits of saving to a 401k
1. Many employers offer a match: For example, you may receive a dollar for dollar or 50 cents on the dollar match up to 4%. Who wouldn’t want to take advantage of the free money?
2. The contribution is with pre-tax money: Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes a cut which increases the value of the dollar you save. For example, say Uncle Sam is taking 20% to cover taxes. You would need to earn $1,250 to save $1,000 as the IRS takes $250.
3. Lower total taxable income for the year: For example, if you made $100,000 this year and contributed the maximum of $19,500 into your 401(k), you will only pay income taxes on $80,500. The government wants you to save for your retirement
4. You get to choose how to invest your funds: It’s your money and you should control how you invest the funds. It’s imperative to look at all your accounts in aggregate to determine the right asset allocation. A Financial Advisor can work with you to review your personal and retirement accounts (including your partner or spouse’s accounts) to determine the most suitable asset allocation. Having the freedom to choose your investments within the options offered by an employer will help you reach your retirement goals.
5. You don’t pay any taxes on the funds until withdrawal: Once the money is in your 401(k) account the growth and earnings are protected from taxation, unlike a brokerage account at Vanguard or Schwab where you pay taxes on investment growth and dividends. After you reach 59 1/2, employees can make withdrawals penalty-free and both contributions and earnings are taxed at ordinary income levels. Prior to 59 ½, withdrawals may be subject to a 10% early withdrawal penalty.
6. You can take your 401(k) with you: Most people don’t stay in the same job forever and that’s okay. If you leave for another job, you can rollover that account into your new employer’s 401(k) or to an IRA. While a rollover will allow the assets to continue to grow in a tax-deferred environment, IRAs are subject to certain limitations so it is important to get some guidance before doing this.
What about a Roth 401(k)?
With a 401(k) Uncle Sam takes taxes out at the beginning. The money in the Roth 401(k) account is post taxes so you do not owe the IRS any money on the contribution or earnings when you start to withdraw the funds.
What is a 403(b)?
A 403(b) plan is a retirement plan for certain employees of nonprofit or tax-exempt organizations (public schools, hospitals, religious groups). Like a 401(k)plan, the 403(b) plan is established by the employer and the employee has an individual account. The 403(b)
There are two basic types of 403(b) plans:
1. A salary reduction plan – accepts ONLY employee contributions
2. An employer-funded plan – accepts BOTH employee and employer contributions
A 403(b) plan has two different catch-up provisions that can be used, in some circumstances, simultaneously:
1. Age 50 Catch-Up Provisions: If you are over the age of 50 you can contribute an additional $6,500
2. 15-Year Rule Provision: If you have worked for the same employer in Health, Education or Religious Organization (HER) for 15 years (not required to be consecutive) then there is a provision to contribute an additional $3,000.
If an employee is over age 50 and worked for their employer for 15 years, they could potentially contribution $19,500 + $6,500 + $3,000 = $29,000 for 2020
Investment Choices and Limitations
Funds within a 403(b) account are more limited investment options than a 401(k) and tend to only invest in either insurance annuity contracts or mutual funds. But it is possible to be invested indirectly in stocks and bonds through these investment options. You may also find that403(b) plans do not offer employer matching contributions as frequently as 401(k) plans.
What is a 457(b) Plan?
This is a retirement plan offered to state and local government tax-exempt entities. It is possible to contribute to a 457 plan AND a 401(k) or 403(b) plan if your employer offers both. Contributions are made pre-tax dollars. There is also generally no 10% early withdrawal penalty from 457 plans but you will pay ordinary income tax on the withdrawals. Withdrawals from 457(b) plans must begin by age 72. 457 plans are more complicated. Read your plan document to get more information on rollovers. Rollover rules for 457 plans are dependent on whether your employer is a governmental entity or not.
Speak with Adviso Wealth today to gain clarity on your decisions before you take your new job.
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