- What they are: Employer-sponsored plans, including 401(k)s and 403(b)s, that provide employees with automatic savings, tax incentives and (in some cases) matching contributions.
- Pros: Contributions may be tax deductible; tax-deferred growth; matching contributions; possible to borrow from plan; possible to use funds for "hardship" withdrawals (e.g. to purchase your first home or to pay for the kids’ college).
- Cons: Early withdrawal penalties; annual limits on contributions
- How to invest: Connect with your employer’s Human Resources (HR) or Human Capital department.
401(k)s and other company plans are known as defined-contribution plans. This is because you - as an employee - contribute to the plan, typically through a payroll deduction each pay period. You decide what percentage of your salary will be contributed, and the deduction is automatically taken out of each paycheck. In some cases, your employer may also contribute to the plan in the form of a matching contribution. For example, your employer may contribute 25 cents for each dollar that you contribute, up to a maximum percentage of your salary (such as 3 to 5%). Though the contribution is known, the benefit - how much money you will get at retirement - is unknown.
The types of plans offered by employers depend upon the company’s structure, and include:
- 401(k)s - offered to corporate employees
- 403(b)s - for employees of public education and most nonprofits
- 457s - for state and municipal employees and certain nonprofits
- Thrift Savings Plans (TSPs) - for federal employees
The Internal Revenue Service (IRS) sets limits for contributions. The limits are periodically adjusted upward in response to increases in the cost-of-living index. For tax year 2013, you can contribute up to $17,500 to a 401(k), 403(b), TSPs, and most 457s. In addition to normal contributions, employees who are age 50 and over can make a catch-up contribution of $5,500 to any of these plans.
Even though you and your employer contribute to your plan, you get to decide how the money is invested. The plans typically allow you to choose from a variety of investment choices, such as mutual funds, stocks (including your company’s stock), bonds and guaranteed investment contracts (GICs; similar to certificates of deposit). If you do not like the investment options offered by your employer, you may be able to transfer a percentage of your plan into another retirement account. This is known as a partial rollover.
It is important to consider your risk tolerance and investment time horizon (how long you have until retirement), and to make careful decisions. In general, people are advised to invest more aggressively when they are younger (and are able to recover from losses) and to make more conservative investments as they approach retirement. As such, you may change your allocations over time. Most plans allow you to make changes whenever you want, while other permit changes only once a month or once per quarter.
Any money that you contribute is yours; however, your company’s matching contributions will not be 100% yours until you are fully vested. Typically, these funds vest over time; for example, after the first year of employment you may be 25% vested, after the second year 50% vested, and so forth. After you are fully vested, all the money in the plan (your contributions plus your employer’s) is yours and you can take it with you if you change jobs or retire.
In general, if you make a withdrawal before you are age 59.5, you will have to pay a 10% penalty tax on the distribution. You will not have to pay the penalty, however, if:
- You suffer a disability
- You have died and the distribution is made to a beneficiary
- You have certain medical expenses
- You buy your first home
- You need funds to pay for college (for you, your spouse or your children)
- You need money to avoid foreclosure or eviction
- You need money for burial or funeral expenses
- You need money to pay for certain repairs to your home
After you turn 70.5, you will have to make required minimum distributions (RMDs). In general, you have to start withdrawing money by April 1 of the year following the year that you turn 70.5. Your age (and life expectancy) and account value determine the required minimum distribution.
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