401(k)s, 403(b)s and TSPs are retirement accounts that you typically open with your employer. 401(k)s are offered by private businesses, 403(b) plans are offered to public education and non-profit employees, and Thrift Savings Plans (TSPs) are offered to federal government employees.
All three plans work essentially the same way, so for the purpose of this post, we'll just be talking about 401(k)s.
How Much Does Your Employer Match?
The first thing you need to figure out is how much of your contribution your employer is wiling to match. This is usually expressed as a percentage, with employers often matching up to 6% of salary. That means for every dollar you contribute up to 6% of your salary, your employer contributes something to match that contribution.
However, it is not necessarily a dollar-for-dollar match. Many employers match each dollar you contribute with $0.50. That means that if you contribute 6% of your salary or more, you get an extra 3% from your employer.
For example, let's assume the employer matches 50% of the employee's contributions up to 6% of their salary. The employee makes $50,000 per year and contributes 10%. The results would be:
- $5,000 from the employee
- $1,500 from the employer (which is 50% of $3,000 or 6% of the annual salary)
- Total: $6,500
So if you are wondering how much to save in your 401(k), start by saving up to the 6% the employer will match. When your employer is putting money into your account that is free money. Anything less is like saying no to that raise you have been waiting for.
Traditional 401(k) vs Roth 401(k)
You may have previously associated Roth accounts only with Individual Retirement Accounts (IRAs), but with more employers offering a Roth option as part of a 401(k) plan, it's important to understand the differences between a traditional and Roth 401(k).
- Pre-Tax (Traditional) 401(k): Contributions made with pre-tax income will result in a tax deduction for the amount contributed. Contributions are not counted as income, and they will lower your tax bill come April. When you contribute pre-tax, you are allowing your assets to grow on a tax-deferred basis. By the time you retire and begin to pull money out of your account, every dollar withdrawn (including the growth) is taxable as ordinary income.
- After-Tax (Roth) 401(K):Roth contributions are the opposite of pre-tax contributions. While this option may not have been widely available in the past, many retirement plans now offer it. When you contribute to these accounts, you won't receive a tax break, but all growth and qualified future withdrawals are tax-free. Because you already paid taxes on this money when you contributed to the account, you won't be taxed on this money when you withdraw it in the future.
Should you pay taxes now or later? The answer depends on many variables, including your current tax bracket and which tax bracket you expect to be in during retirement. If you are trying to decide which option is best for you, we would be glad to review your plan and discuss which option is best for you.
Vesting: The Rate of Your Employer Match
Vesting is where employer matching gets a little tricky. Vesting is the access that you can have to your full match over time. if you are fully vested, your employer matching funds are all yours.
If you leave the company, you can take the money with you. Many employers have a graded vesting schedule, which gives employees increased access to matching funds the longer they serve the company.
With a typical vesting schedule, you may not be able to participate in the 401(k) until your second year as an employee.
Your vesting may then increase by 25% each year until you are fully vested after 5 years as an employee. This is one way employers can encourage loyalty in a competitive job market. If you are 50 percent vested when you leave a company, that means you only leave with 50 percent of your employer's intended match.
If you have previously left a job where you had a 401(k) and would like to discuss what your options are, please give us a call. We would be happy to review your vesting schedule as well as discuss the options that are available to you for no cost.
Jamie Taylor, CDFA®
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