Yesterday, I covered the difference between a defined benefit plan and a defined contribution plan. Today, I explore the basics of the most common types of defined contribution plans. As a heads up, the names associated with the plans merely refer to the part of the Internal Revenue Code that outlines the plan (e.g., Section 401, paragraph k).
Both private and public for-profit employers offer this type of plan. It comes in two varieties: 1) Regular 401k, where you invest pre-tax dollars and 2) Roth 401k, where you invest after-tax money. (I will get into why you would do one over the other later in the week.)
For 2013 and 2014, you can contribute up to $17,500, with an additional $5,500 if you are age 50 or over. Your employer also has the option to match a portion of your salary (i.e., put in a dollar for every dollar you invest up to a certain percentage of your salary) and/or contribute through sharing business profits. In either scenario, make sure to take advantage of this free money.
The employer contributions usually have a vesting schedule. Meaning, you only have access to a certain percentage of your employer’s contributions every year until you have been with the employer a certain period of time (usually three to five years). Your contributions, however, always vest immediately.
With these retirement plans, if you take money out of your account before age 59 ½ (called a distribution), you may incur a 10 percent federal tax penalty. You can avoid the penalty if you take a “hardship” distribution. Each plan’s rules vary, but generally, you can avoid the penalty on withdrawals for:
- Higher education expenses
- Purchasing your first home
- Paying for expenses related to a sudden disability
- Payments to prevent eviction or foreclosure
See irs.gov for additional information on penalty-free withdrawals.
Your plan may also allow you to take a loan from your account and pay yourself back, with interest, over a certain period of time. You should avoid taking loans as much as possible. You almost always lose money because of the loss of compound interest on your investment and double taxation on the money with which you pay back the loan.
Employees of public schools, certain ministers, and certain tax-exempt organizations like hospitals, charities, or churches invest in these plans. Who can participate in and sponsor the plan is really the only thing that distinguishes it from a 401k. As with the 401k, you can make pre-tax contributions (regular 403b) or post-tax contributions (Roth 403b). In 2013 and 2014, you can contribute up to $17,500 or $23,000 if you are 50 or over. And withdrawals before 59 ½ are subject to 10 percent tax penalty, unless you qualify for a hardship distribution.
State and local municipal governments sponsor these plans. Similarly to the 401k and 403b plans, you can choose regular or Roth contributions. However, with these plans, you can withdraw money without penalty and regardless of age, if you retire or separate from service. However, withdraws while employed in the public sector are not allowed until age 70 ½.
The other cool thing about the 457 plan is that some employers offer both 457 and a 403b or 401k plan. In that case, you, as the employee, can contribute the max to both accounts and substantially boost your retirement savings.
Thrift Savings Plan
Lastly, the Thrift Savings Plan covers federal government employees. The contribution limits, distribution rules, and withdrawal penalties mirror that of the 401k and 403b plans.
You’re on your own
You must remember that no matter who sponsors the plan, you have the responsibility of contributing money, picking your investments, and making sure that you save enough for retirement. You shouldn’t take that responsibility lightly.
Haven’t seen your plan yet? You may work for a very small employer or work for yourself. I’ll cover your options tomorrow.