What on Earth is a 401k?

Ever get confused by all the different retirement plans out there? Have trouble telling the difference between a 401k and an IRA? Do you know you need to start saving for retirement but don’t know what’s available to you? If you answered yes to any of these questions, this is the article for you.

Generally speaking, retirement plans are mechanisms used to protect your investments from taxes so your money has more growing power as you prepare for retirement. There are many options available and they can sometimes get confusing, so I wanted to shed some light on some of the most common ones.

Here is a brief description of the different types of retirement investment plans available to most people:

1. 401(k) – Allows you to invest pre-tax dollars into a selection of investment options. Your contributions grow tax-deferred, meaning you don’t pay taxes until you start collecting distributions at retirement. Many companies match a portion of your contributions to encourage you to invest. There are limits to the amount you can contribute each year, depending on your age.

2. Traditional IRA – Allows you to invest pre-tax dollars into a selection of investment options. Your contributions grow tax deferred. Traditional IRAs have more investment options than 401(k) programs but usually do not have a company match associated with it. Contribution limits also apply, depending on your age.

3. Roth IRA – Allows you to invest after-tax dollars into a selection of investment options. Since you already paid taxes on the money you invest, your account grows tax free. You do not pay any taxes when you take distributions during retirement. As with the traditional IRA, limits apply to your annual contributions.

4. 403(b) – This option is usually available for teachers, clergy, some medical personnel, etc. It is a non-profit pre-tax plan where your money grows tax-deferred. Some plans provide company matches.

5. 457 Plan – Usually offered to state and local government employees. Allows you to defer compensation by investing it pre-tax. Contributions grow tax-deferred, with a selection of options to invest in. Most plans offer minimal matching.

6. Thrift Savings Plan – Typically offered to government employees, this plan offers pre-tax contributions with tax-deferred growth. There are five managed investment options available. A minimal agency match is available.

7. Simplified Employee Pension Plan (SEPP) – For self-employed people. This plan allows pre-tax contributions up to 15% of net business profit. Contributions grow tax-deferred, and the selection of investment options are self-directed.

Since these are all retirement plans, you generally cannot withdraw money before retirement age without paying penalties (some exceptions apply but it’s not a good idea to pull your money out early). Each plan has different limits on the contributions you can make each year, so you may want to check with your plan administrator for details.

In future issues, we will discuss the pros and cons of the different plans, and when it makes sense to use each one.

Matt Wegner is a Certified Financial Counselor with the heart of a teacher. Matt helps people in all walks of life take control of their financial destinies by teaching them the mechanics of making sound financial decisions. Find out more about Matt at www.financialexcellence.net.