1 in 2 people reading this blog post have the option to make retirement investments through your employer through a 401(k) or 403(b). While that’s not all employers, there is an increasing push for companies to offer some retirement savings options. While the two types of plans share a number of similarities, there are also differences worth noting – most of which have to do with the nature of your employment.
What’s a 401(k), anyway?
A 401(k) plan is a tax-advantaged investment vehicle, or account, offered to employees of for-profit companies. It’s also the most common type of employer-sponsored retirement plan. A significant percentage of corporate employers utilize 401(k) plans as a method to enable their employees to save money for retirement, usually on a tax-deferred basis. This means that you’re able to take a portion of your paycheck – before it’s taxed – and invest it for your benefit. You’ll only need to pay taxes when you actively withdraw the money, which for most people, happens in retirement.
Some employers offer Roth 401(k)s, which are similar to traditional 401(k)s but work in the opposite manner. Money contributed to a Roth 401(k) comes from your after-tax wages, but the upside is that you’ll never need to pay tax on Roth money ever again – even when you go to withdraw money in the future. A Roth 401(k) is usually best suited for those who believe their tax rate stands to increase in the future. In other words, they plan to earn more money at the time of retirement than they did when contributing to their Roth 401(k).
For example, say you were to take $1,000 from your current paycheck and deposit it to a Roth 401(k) – assuming an 8% annual rate of return and a time horizon of 30 years, you’d end up with just over $10,000 of tax-free money in retirement. You read that right – in a Roth 401(k), all growth and earnings remain tax-free forever, and you’d only have paid tax on the original $1,000 contribution. So if you’re in a low tax bracket today, it’s certainly not a bad idea to give the Roth 401(k) a look.
One of the main features of employer-sponsored 401(k) plans is that they’re protected by ERISA (“Employee Retirement Income and Safety Act”) standards, which are legal requirements that were written to protect savers. ERISA rules require that employer-sponsored plan managers act as fiduciaries; that is, those who control plan assets are required to act in the best interests of the plan beneficiaries. Essentially, ERISA standards protect the people that actually contribute to retirement plans – a group that includes you – as patterns of mismanagement and discrimination had unfortunately become commonplace before such standards existed.
401(k) plan matching
Another major feature of the typical 401(k) plan is the employer-matching contribution. Employers often offer a cash match for any amount contributed to their 401(k) plan, typically capped at a certain amount of your compensation. Anywhere from 2% to 8% is typical, but the middle of the range tends to be more common. For example, a worker earning $100,000 annually and receiving a 4% employer-match could contribute up to $4,000 by themselves and receive an additional $4,000 from their employer – for a total of $8,000. Higher balances ultimately lead to faster compounding, which can help people build wealth much faster than they would otherwise.
Regarding annual 401(k) contribution amounts, you’re eligible in 2022 to contribute up to $20,500 ($27,000 if age 50 or older) from your own compensation into the plan, which excludes any amounts contributed by your employer. The limit for total contributions to a 401(k) in 2022 – that’s employer plus employee contributions – is $61,000 ($67,500 if age 40 or older).