Once upon a time when you retired your employer would hand you a gold watch and send you a monthly pension check for the rest of your life. Sadly, those days are gone. Now we are stuck planning our own retirement.
To replace the pension, most organizations went with a qualified retirement plan. The “qualified” part refers to the fact that the plan complies with all of the IRS rules and regulations. Depending on the type of organization you work for, they will offer you a 401(k), 403(b), TSP, or 457(b) plan. By the way, we have the IRS to thank for those catchy names.
The 401(k) has been around since 1980 and is the most popular and best-known type of employer-sponsored retirement plan. Employee contributions up to the IRS limits are tax deductible. All growth and dividends in the plan are sheltered from taxes. Taxation does not occur until you start taking money out of the plan, which normally occurs during retirement.
The IRS sets limits on 401(k) employee contributions. In 2023 the annual limit is $22,500 plus another $7,500 “catch-up” allowance for those age 50 and older.
Contributions made by the employer are referred to as “matching” because the employer matches the employee’s contributions. That is, the employer contributes to the employee’s account in response to the employee’s contributions and in direct proportion to them. The employer match can be anywhere from 0 to 100 percent of the employee’s contribution. An employer match is typically capped at a certain limit expressed as a percentage of the employee’s annual gross income.
Let’s look at an example. Randy earns a gross annual income of $50,000 from his employer, Raleigh Real Red Rubber Raincoats. The company’s 401(k) plan provides a 50 percent match on employee contributions up to a maximum of 6 percent. Randy puts 12 percent of his gross annual income into the 401(k) plan which equates to $6,000 per year ($50,000 x 0.12). His employer matches the first 6 percent at a rate of 50 percent which comes out to $1,500 ($50,000 x 0.06 x 0.50). Each year a total of $7,500 goes into Randy’s 401(k) account. More will be remitted when Raleigh Real Red Rubber Raincoats rewards Randy with a raise.
“Arrrrrrr!” says Captain Jack. “That’s a lot of ‘R’s.”
Employer matching contributions are subject to vesting requirements. An employer can specify an amount of time that must elapse before an employee may lay claim to the matching contributions. The vesting period varies by company but is typically set at about one year.
The employee is free to choose from a variety of stock and bond mutual funds available within the plan. Although past performance is no guarantee of future performance, it’s always a good idea to evaluate your options. Each investment carries its own degree of risk and reward.
TSP is an acronym for Thrift Savings Plan. TSP plans are for employees of the federal government and members of the armed forces. A TSP account works just like a 401(k) plan with the exception that matching contributions cannot exceed 5 percent. Matching contributions for a 401(k) plan are unlimited.
A 457(b) plan is basically a 401(k) plan for state and local government workers. Other than the name and the type of organization that uses it, a 457(b) plan is identical to a 401(k) plan.
A 403(b) plan is essentially a 401(k) plan for non-profit organizations such as churches, charitable organizations, hospitals and schools. A 403(b) plan functions identically to a 401(k) plan.
Regardless of the name that it goes by, you should be participating in your employer’s qualified retirement plan. The simple truth is that Social Security is not enough to live on, you need to save up your own nest egg.
If you are not participating in the retirement plan at work, you are missing out on free money. You receive only 100 percent of your salary if you don’t participate in the plan, but if you do participate you will receive 103 percent of your salary (based on an estimated 50% match capped at 6%).
If you are not currently participating in your employer’s retirement plan, you should sign up at the next open enrollment. If you think you can’t afford it, start small and increase the percentage you save each year. Your older self will be glad you did.Photo credit: Pixabay