How a Retirement Savings Plan Works
Employer-sponsored retirement savings plans, such as 401(k), 403(b), and 457 plans, present an ideal opportunity to build a nest egg for retirement. You contribute to the plan via payroll deduction, which can make it easier for you to save for retirement. In addition, you may receive significant tax benefits along the way. Following is a brief overview of how your plan works.
"Pre-tax" means that your contributions are deducted from your pay and contributed into your plan account before federal (and most state) income taxes are calculated. This reduces the amount of income tax you pay now. Moreover, you don't pay income taxes on the amount you contribute — or any returns you earn on those contributions — until you withdraw your money from the plan.
Example(s): Taylor earns $60,000 a year and contributes 6% of his salary, or $3,600, to his plan on a pre-tax basis. Because of his plan participation, his taxable income is reduced to $56,400. He won't be taxed on those contributions or any earnings on them until he takes money out of his plan.
Your plan might also offer a Roth account. Contributions to a Roth account are made on an after-tax basis. Although there's no up-front tax benefit when contributing to a Roth plan, withdrawals of earnings are free from federal income taxes as long as they are "qualified." (Note: With Roth accounts, taxes apply to withdrawals of earnings only; withdrawals of contribution dollars are tax free.)
Generally a withdrawal from a Roth account is qualified if:
- It's made after the end of a five-year waiting period (starting on January 1 of the year you make your first contribution) AND
- It's made after you turn 59½, become disabled, or die
Because employer-sponsored savings plans were established to help American workers prepare for their retirement, special rules are in place to discourage people from taking money out of the plan prior to retirement. With certain exceptions, taxable withdrawals from traditional (i.e., non-Roth) accounts prior to age 59½ and nonqualified withdrawals of earnings from Roth accounts are subject to both regular income taxes and a 10% penalty tax.
Traditional or Roth?
The decision of whether to contribute to a traditional plan, a Roth plan, or both depends on your personal situation. If you think you'll be in a similar or higher tax bracket when you retire, you may find Roth contributions more appealing since qualified income from a Roth account is tax free. However, if you think you'll be in a lower tax bracket in retirement, then contributing to a traditional pre-tax account may be more appropriate. A tax advisor can help you decide.
Employer matching contributions
Employers are not required to contribute to employee accounts, but many do through what's known as a matching contribution. Your employer can match your pre-tax contributions, your Roth contributions, or both. Most match programs are based on a certain formula — say, 50% of the first 6% of your salary that you contribute. If your plan offers an employer match, be sure to contribute enough to take maximum advantage of it. The match is a valuable benefit offered by your employer. In the example formula above, the employer is offering an additional 3% of your salary to invest for your future. Neglecting to contribute the required amount (and therefore not receiving the full match) is essentially turning down free money.
Often, employer contributions are subject to a vesting schedule. That means you earn the right to those contributions (and the earnings on them) over a period of time. Keep in mind that you are always fully vested in your own contributions and the earnings on them.
Eligibility rules and contribution limits
You can contribute to your employer's plan as soon as you're eligible, as defined by the plan documents. Some plans will require up to a one-year waiting period, while others allow you to participate right away.
Still others provide for automatic enrollment, which means you will automatically be enrolled in the plan unless you specifically opt out. The automatic contribution amount may be lower than you would want to contribute, and your contributions will be placed in the plan's default investment. So if you've been automatically enrolled in your plan, be sure to check the contribution amount and investment selection to make sure they are appropriate for your needs.
The IRS imposes combined limits on how much participants can contribute to their traditional and Roth savings plans each year. In 2020, that limit is $19,500.
Participants age 50 and older can make additional "catch-up" contributions of $6,500 per year. [Special catch-up limits apply to certain participants in 403(b) and 457(b) plans.]
One smart move
An employer-sponsored retirement savings plan offers a tax-advantaged opportunity to save for your future. Participating in your plan could be one of the smartest financial moves you make.