With traditional pension plans rapidly becoming phased out and Social Security’s long-term future in doubt, more Americans shoulder the responsibility of funding their own retirement. Many workers rely increasingly on their workplace-sponsored retirement plans to provide the means to meet their investment goals. That’s because these types of plans — such as a 401(k), 403(b), or 457 — offer a variety of attractive features that make investing for the future easy.
Tax Treatment
401(k), 403(b), and 457 plans allow you to contribute up to $17,500 of your salary in 2013. Keep in mind that individual plans may have lower limits on the amount you can contribute. In addition, individuals aged 50 and older who participate in these types of plans can take advantage of so-called “catch up” contributions of an additional $5,500. Note that non-governmental 457(b) plans are not eligible for catch-up contributions.
In all cases, contributions to the plan are made before taxes are withdrawn from your salary, giving you the immediate advantage of lowering your taxable wage base. For example, if your salary is $50,000 and you contribute $5,000 to your plan, your wages for income tax purposes are lowered to $45,000 (excluding FICA and Medicare taxes).
All contributions to your account may grow on a tax-deferred basis, meaning that you don’t pay taxes on the contributions and any earnings until they are withdrawn at retirement.1
401(k) and Roth 401(k)
401(k) plans now come in two varieties: traditional and Roth-style plans. Your employer may offer just one type or both. A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pre-tax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.
The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit. However, plan balances grow tax free; you pay no taxes on qualified distributions.
Both traditional and Roth plans require that distributions be qualified. In general, this means they must be taken after age 59½ (or age 55 if you are separating from service from the employer whose plan the distributions are withdrawn from), although there are certain exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% IRS additional tax will apply in addition to ordinary income taxes on all pre-tax contributions and earnings.
Choosing Investments
Generally, workplace retirement plans provide you with several options in which to invest your contributions. Such options may include stocks, bonds, and money market investments. This flexibility allows you to spread out your contributions, or diversify, among different types of investments, which can help keep your retirement portfolio from being overly susceptible to different events that could affect the markets.
Borrowing From Your Retirement Plan
One potential advantage of many workplace retirement plans is that you can borrow as much as 50% of your vested account balance, up to $50,000. In most cases, if you systematically pay back the loan with interest within five years, there are no penalties assessed to you. If you leave the company, however, you may have to pay back the loan in full immediately, depending on your plan’s rules. In addition, loans not repaid to the plan within the stated time period are considered withdrawals and will be taxed and penalized accordingly.1
Make It Work for You
A workplace retirement plan can become the cornerstone of your personal retirement savings program, providing the foundation for your future financial security. Consult with your plan administrator or financial advisor to help you determine how your employer’s plan could help make your financial future more secure.
1Withdrawals made prior to age 59½ may be subject to an additional 10% penalty tax.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
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