401(k) retirement plans are retirement savings plans funded by contributions made by you as an employee and, frequently, matching contributions made by your employer. It's important to compare your options to make the best choices with your money.
Traditional vs Roth
There are two main variations on 401(k) plans: Traditional and Roth. The distinction has to do with whether your contributions are taxed before they go in (Roth) or when they come out (Traditional) at retirement. Earnings accrue on a tax-deferred basis no matter which type of account you have.
Rick Rodgers, of Rodgers & Associates, says total income is an important consideration when choosing a retirement vehicle. "Higher income taxpayers," Rodgers says, "cannot make Roth contributions except through a Roth 401(k) because of phase-out rules that impact the amount you can contribute to a Roth IRA based on your income. A Roth 401(k) may be the only way for these taxpayers to put money into a Roth."
You Can Have Both
As far as choosing between Traditional and Roth 401(k) plans, Rodgers says that actually with most employers you can have both. He suggests that you only want to make pre-tax 401(k) contributions to keep you below the 25 percent tax bracket maximum. That level, in 2013, is $36,250 for single taxpayers and $72,500 for joint. Additional contributions, Rodgers says, should all be to a Roth 401(k) once you are at these levels.
Things 401(k) Plans Have in Common
All 401(k) plans have the following things in common:
- Your employer establishes them.
- There is no general limit on the amount of income you can earn and still participate. This is somewhat complicated due to HCE (highly compensated employees) rules.
- Depending on the plan, most allow for loans when you are still employed. Loans may not be more than 50 percent of the account balance or $50,000.
- All capital gains, dividends, and interest accrue tax free while in the account.
- You can move your contributions to another plan if you change jobs.
- You have a measure of control over investments.
- Employers often match your contributions.
- 401(k) funds are protected from creditors, except domestic relations court cases dealing with divorce or child support orders.
Contribution Limits for 401(k) Plans
Contribution limits for both employees and employers vary, depending on the tax year. Note that the limits change each year, based on inflation. It is always wise to check the IRS website for updates, which can happen at any time.
For the 2012 tax year, you are limited to $17,000 unless you are 50 or older, in which case you may contribute an additional $5,500. The combination of your contribution and any contribution made by your employer must be the lesser of 100 percent of your salary or $50,000. ($55,500 for those age 50 and above.)
For the 2013 tax year, the contribution limit increases to $17,500 for those under 50. The additional catch up amount for those 50 and older remains at $5,500. The combination of your contribution and that made by your employer must be the lesser of 100 percent of your salary or $51,000. ($56,500 for those age 50 and above).
Differences between Traditional and Roth 401(k) plans:
For Tax Year 2012
|Employer Matching||Yes, depending on your employer.||Yes, depending on your employer, but must be in a pretax account.|
|Distributions||Unrestricted at age 59½, or if you become disabled.||Unrestricted at age 59½ (55 if you leave your job), and the account has been open for at least five years, or you become disabled.|
|Required Minimum Distributions||After age 70½, unless you are still employed and do not own five percent or more of the company for which you work.||Same as Traditional, however, if you roll over to a Roth IRA, there is no RMD.|
|Withdraw Before 59 ½||10 percent penalty plus taxes. There are some exceptions to this penalty.||10 percent penalty on the taxable part of the distribution plus you will pay taxes on earnings. There are some exceptions.|
Upon termination of employment, you can roll your 401(k) into an IRA or Roth IRA. When rolled to a Roth IRA, you must pay taxes during the year of the conversion.
|You cannot convert a Roth 401(k) to a traditional 401(k), but upon termination of employment, you can roll it into a Roth IRA.|
|Conversion/Rollover in 2013|| |
Beginning in 2013 you can roll your Traditional 401(k) into a Roth 401(k) if your company offers a Roth option.
|Job Change||You can roll over your 401(k) to another employer's 401(k) plan or to a traditional IRA at an independent institution.||You can roll over your Roth 401(k) to another employer's Roth 401(k) plan or to a Roth IRA at an independent institution.|
Making a Decision
In general, a Roth 401(k) makes sense if you believe you will be in a higher tax bracket when you retire than the one you are in now. If you are unsure, you may want to check with a 401(k) professional or use an online calculator to estimate whether it is better to contribute Roth deferrals or regular deferrals, or some combination of both.
Whichever way you go, a 401(k) retirement plan is one of the best ways to save for retirement. Retirement living takes planning, and now is the time to start if you want to enjoy an independent lifestyle in your golden years.