You’ve undoubtedly heard the phrases 401(k), 403(b), IRA, Roth, TSP, and 457 plans. Do you know what they mean? Are these the latest Levi blue jeans? Are these the new and approved Mazda, Honda, Lexus series? If you’re having a difficult time sorting out the “alphabet soup” of retirement plans, don’t feel ashamed. While many people have heard of the different types of retirement plans, very few understand the difference between these plans. If you ever sat in on one of those 401(k) meetings at work or met with a financial adviser, you’ll understand why. Most financial professionals use a language that’s suited for another financial geek, not the everyday layperson.
In this article, you’ll get a basic overview of the various retirement plans written in everyday English.
Traditional IRA (Individual Retirement Arrangement. An IRA is a tax-advantaged individual retirement arrangement that allows contributions and earnings to grow “tax-deferred.” That means you don’t pay income taxes on the earnings of your contributions to a Traditional IRA until you begin taking withdrawals, usually after you retire. Depending on individual circumstances, contributions may or may not qualify for a current year tax deduction. As of 2007, you can contribute up to $4,000 to an IRA. People age 50 and over can make an extra $1,000 “catch up contribution” for a total of $5,000. Distributions made from an IRA before age 59 are subject to a 10 percent penalty unless you qualify for an exception.
Roth IRA (Individual Retirement Arrangement). Contribution limits to a Roth IRA are the same as they are for a Traditional IRA. The primary distinction between a Traditional IRA and a Roth IRA is the fact that contributions to Roth IRAs are made with after-tax dollars. There are no tax incentives on the front end. However, contributions and earnings within a Roth IRA grow “TAX FREE.” Tax-free growth is better than tax deferred growth. Another distinguishing feature of the Roth IRA is that there are no required minimum distributions when you reach age 70 and high-income earners cannot currently contribute to a Roth. However, in 2010 there’s no longer an income restriction to convert money from a traditional IRA to a Roth IRA.
401(k) plan. A 401(k) plan is a retirement plan sponsored by for-profit employers. As of 2007, employees may choose to save and shelter from taxes up to $15,500 per year of their salary into any of the 401(k) investment choices selected by the employer. People age 50 and over can make an extra $5,000 “catch up contribution” for a total of $20,500. Money invested inside a 401(k) plan grows tax deferred. The employer may also contribute to the employee’s 401(k) by matching a portion of the investment (for example, $.50 for every $1 the employee invests). Always consider investing up to the match. It’s a free, guaranteed return on your investment.
403(b) plan. A 403(b) plan is essentially the 401(k) plan available to tax exempt organizations such as public schools, churches, and other organization with tax exempt status under IRS code Section 501 (c) (3). It has the same characteristics and benefits of a 401(k).
Roth 401(k) and Roth 403(b). In January 2006 the Roth 401(k) and Roth 403(b) came into existence. The Roth 401(k) and 403(b) essentially implement the benefits of a Roth IRA to these respective plans but they retain the higher $15,500 contribution limits. Like the Roth IRA, contributions are made to these plans with after-tax dollars. Contributions and earnings within a Roth IRA grow “tax free.”
457 plan (Deferred Compensation plan). The 457 plan is essentially the 401(k) plan available to state and local governmental employees and employees of certain non-governmental organizations that are exempt from taxation. The employer provides the plan and the employee defers compensation into it on a pre-tax basis.
Thrift Savings Plan. The Federal Thrift Savings Plan is a retirement savings plan for civilians who are employed by the United States government and members of the uniformed services. The TSP offers federal employees the same type of savings and tax benefits that many private corporations offer their employees under 401(k) plans.
Simplified employee pensions. A pension plan in which the employer contributes to an Individual Retirement Account for each of its employees. The employee is vested immediately and pays no taxes on the employer’s contributions. The contributions and all earnings on funds in the plan are tax-deferred until withdrawn.
Savings Incentive Match Plan For Employees. Small employers may establish a savings incentive match plan for employees retirement plan with annual contributions up to $10,500 as of 2007. A simple plan can be either an IRA for each employee or deferred arrangement, such as a 401(k) plan
Keogh Plan. Keogh plans are the self-employed equivalent of corporate retirement programs. They come in two basic flavors: profit-sharing plans and defined benefit pension plans. The individual may contribute up to $45,000 or 20 percent of total earned income per year whichever is less.
Solo 401(k). A solo 401(k) plan is a regular 401(k) plan combined with a profit-sharing plan available for small business owners who don’t have employees. (An exception applies if your full-time employee is your spouse). With a Solo 401(k) plan the sole proprietor and spouse may contribute as an employee up to $15,500 per year. They can also make matching contributions as an employer up to $45,000.
Annuities. An annuity is a savings program with an insurance company. Annuity vehicles offer similar tax incentives the plans listed above offer. There are no contribution limits and no earning requirement for annuities unless the annuity is associated with a qualified retirement plan. For retirement saving purposes, annuities should only be considered after you’ve reached the saving limits with other retirement vehicles.
(Mortgage and Money Coach Damon Carr is the owner of ACE Financial. Sign up for his FREE Online Newsletter at www.allcreditexperts.com. Damon can be reached at 412-856-1183.)