401(k), 403(b), 457(b), defined benefit plan, Roth IRA, pension plan... What do all of these numbers and words have in common? They refer to common retirement plans. But what are the differences between each? How do you know which plan is right for you? An easy way to understand the differences is to know that the plans that have numbers are offered by your employer, the plans without are ones that you will have to set up on your own. For employer sponsored plans, you will need to know what that plan specifically entails and how you can get the maximum benefits out of your retirement fund.
A 401(k) plan is a retirement plan that allows employees to invest in their retirement, usually with an employer match. Sound kind of confusing? No worries! Here is an example of how it works. Let's look at an income of $50,000 per year. If your employer offers a match on your yearly contributions with a 4% limit of your annual income; the MOST your employee will contribute for that year is $2,000. To receive this, you must also contribute $2,000. If you decide to contribute more than the $2,000, then that is awesome for you, but your employer will still not go above the $2,000 match.
How Much Can Be Contributed
The IRS controls how much you can contribute yearly, and it can change from year to year. The 2017 tax year maximum 401(k) contribution for one person was $54,000 or 100% of compensation, whichever was less. Your age and elected salary deferrals might make this number change. So, it is important to read up on that information so you know exactly what rules will apply to you.
For tax year 2018, the IRS has increased this contribution amount to $18,500. If you are an employee participating in a 401(k), 403(b), or a government Thrift Savings Plan this new dollar amount applies to you.
What this Means for You
If your company offers a match it is important that you contribute at least that much to your 401(k), otherwise you are leaving money on the table. This is basically free money that your employer is willing to contribute to your retirement fund, but if you do not meet the minimum match, they will not put the money in. It is also important to understand that your contribution is taken out of your paycheck BEFORE any taxes are applied. For example, if your paycheck is $2000 and you have elected to contribute 5% to your 401(k); $100 is deposited to your retirement account and then you are taxed on $1,900 of earnings. Even though you are not taxed at the time of contribution, you do not get away tax free. You will be taxed on the money when you withdraw it during your retirement years.
IRA stands for individual retirement account. If your workplace does not have a retirement plan, and IRA is a good way to start saving for retirement. There are two types, a Roth IRA and a traditional IRA. The general rules for IRAs are: anyone can contribute to an IRA account, contributed money has to be earned income (earned income is salaries, wages, tips, bonuses, etc.), and passive income (money earned through investments) cannot be contributed.
How Much Can Be Contributed
There are limits on the amount that can be contributed to a traditional IRA. The 2018 amount is $5,500 per year, or if you over 50 years old, it is $6,500 per year. Your contribution is also limited by your total earned income. This just means that you cannot contribute more than your total earned income. Basically, if you have been working part time and earned $4,000 for the 2018 tax year, the max amount you can contribute to an IRA is $4,000.
If you have contributed to both an employer sponsored 401(k) and a traditional IRA it will be a bit more complicated at tax time. The amount of your deduction will be affected or limited by your adjusted gross income. For more information on this, check out this helpful article or talk with a tax specialist. They'll for sure know how to help you.
Like a traditional IRA, there is not an age restriction on a Roth IRA, but your eligibility is restricted by your income. In 2018 if you file as single, your adjusted gross income has to be less than $135,000. If you are married and filling jointly then your adjusted gross income has to be less than $199,000.
The tax benefits of a Roth IRA can be seen when you withdraw your money in your retirement years. The money withdrawn is not taxed because you paid your taxes before you ever put the money into the Roth IRA. Another benefit is that a Roth IRA doesn't require you to withdraw your money at a certain age, unlike the traditional IRA which requires withdrawals of a certain percent begin at 70 ½ years old. For a better, more in depth explanation of the differences between the two IRAs check out this article from NerdWallet.
Pension plans are divided into two different groups: defined benefit plans and defined contribution plans. Defined contribution is a plan where you can contribute, or both you AND your employer can contribute at a scheduled time. Future benefits paid out fluctuate based on the investment returns.
The defined benefit plan is different because it guarantees you as the employee will receive a certain amount each month during retirement regardless of how the investment performs. This retirement amount will vary from company to company but age, number of years with the company, and your salary all figure into the computation.
What Is Best
401(k)s offer the most flexibility, particularly if you want to change jobs. But you may not have a choice. Often times employers only offer one choice. The public sector covers jobs like law enforcement, teaching, and military just to name a few. These positions are typically covered by pension plans.
403(b) plans are tax sheltered annuities that are retirement plans offered to certain employees of public schools, tax-exempt organizations, and certain ministers. Adjusted gross income and filing status are used to determine the allowed contribution per tax year. In many ways a 403(b) is similar to a 401(k).
Yes, retirement planning is a bit complicated. There are unfamiliar words and all sorts of rules and recommendations. And if you are young, it is hard to motivate yourself to think about retirement when it feels so far off. It might fit better in your schedule to try learning this information in smaller doses. Trying reading about it or watching videos for an hour a week for 6-8 weeks.
If your workplace offers a retirement plan take advantage of it and don’t hesitate to ask the plan administrators for details and explanations. Visit Nerdwallet for more advice on which retirement plan might be best for you. Consider reading some of these books about retirement planning, or watch these Forbes recommended videos.
If your employer is not offering a retirement plan, then you will have to budget and set aside this money. Download our free budgeting worksheet to make sure your future is being covered.