Tax season is upon us, which has many of us thinking money. In my previous post, and beginning of this money series, we discussed the difference between saving and investing and the need to do both. This week, let’s focus a little more on the investing side. Specifically your 401(k) plan. After all, we should be doing what Paul Clitheroe (financial analyst and advisor) said when he said, “Invest in yourself. Your career is the engine of your wealth.”
By definition, a 401(k) is a retirement plan where an employee can contribute wages (pre or post-tax), sometimes being matched by their employer, into a fund set aside specifically for retirement expenses. Chances are you have one in place already. But did you know there are several different types of options available? And are you using the best plan for you?
Let’s look at some options available:
Traditional/Roth 401(k): Many employers sponsor either a traditional 401(k) or a Roth 401(k), the only difference being the timing of tax deductions. Both offer tax advantages, whether immediate or in the future. Traditional 401(k) options allow you to defer income taxes on contributions and earnings. A Roth 401(k) defer contributions until after taxes, meaning tax benefits comes later: your earnings may be withdrawn tax-free in retirement. With both, often your employer will offer to make monthly contributions in addition to your own withholdings. Income taxes on any matched contributions are also deferred until savings are withdrawn. If your employer offers one of these options, it’s a good idea to take advantage of the benefits they offer.
When comparing Traditional 401(k) plans with Roth 401(k) plans, you’ll often hear financial advisors compare the different approaches on taxation to a seed versus a harvest. Because Traditional 401(k) options allow you to defer income taxes, that means your taxes will be paid on the plan’s earnings, later on the “harvest” of your investment. That may end up being a larger tax liability, which is why many situations make the Roth 401(k) a very attractive options. Depending on your situation and goals, if you allow your 401(k) contributions (the “seed”) to be taxed as income, then you are not taxed on the “harvest” when your plan begins to pay out later.
Self-Directed 401(k): This is similar to traditional 401(k) options in that self-directed 401(k)s allow for pre-tax savings and automated paycheck deductions, but differs in that the employee acts as the fund manager. He also has a much broader array of investments options to choose from and isn’t as limited to only traditional mutual options.
Solo 401(k): This plan is a good choice for self-employed or individuals who have no full-time employees other than the business owner and spouse. Both are allowed to contribute to the same plan. This allows the employees to save for retirement by designating funds to 401(k), not having to pay taxes on them until the individual reaches retirement age. Because this plan only covers the employer and a spouse, it is not subject to ERISA (Employee Retirement Income Security Act of 1974). Individuals who qualify for this 401(k) plan will receive the same tax benefits as a traditional 401(k) plan. This is potentially a very valuable type of plan, so stay tuned. I will be discussing on the blog next week more benefits of the Solo 401(k).
Safe-Harbor 401(k): These types of plans were set up by the Small Business Job Protection Act in 1996 because many businesses were not setting up 401(k)s for their employees, apparently the non-discrimination policies in them were too difficult to understand. This type of plan prohibits employers from contributing more than 5% of the employees compensation. This is a plan that allows the employer “safe harbor” from compliance concerns, while still providing a simplified product.
Tiered Profit Sharing 401(k): This is a plan usually used by smaller companies, usually with less than 50 employees. In it, employees are classified by their varying salary structures. The owner shares company profit among the groups, rewarding them according to their contribution to the company’s success.
Simple 401(k): This is a plan also for smaller companies, with employees totaling less than 100 who are compensated $5000 minimum each. Both employer and employee contributions are fully vested. In this plan, the employer has two options: either match employee contribution up to 3% of their pay, or a non-elective contribution of 2% of the employee’s pay.
Is your head swimming yet? With all the options available, making a decision may sometimes feel overwhelming. The key is to educate yourself on what is out there, consult a financial advisor, and make an educated decision based on what is best for you. Every situation is different so thereby calls for a specified plan. If you don’t currently have one, decide today to invest in a 401(k). The risks will always be there, but so will the benefits.
“In investing, what is comfortable is rarely profitable.”
– Robert Arnott
Let me Know: What experiences (positive or negative) do you have with any of the above listed plans?