Help! I Don’t Know What Retirement Plan You’re Talking About!

Connie writes in:

Roth, IRA, 401(k), 403(b), FERS, TSP – what on earth does it all mean? I know they all have to do with retirement savings, but it’s all just a word salad to me.

This is going to be something of a “dictionary” post where I spell out, as simply as I can, what these terms mean and what it means for you. I’m not going to get into every single detail of each term, but instead I want to give you enough information that you can sensibly navigate other articles you might read about retirement planning.

A 401(k) is a retirement plan, meaning it’s a special way for you to put aside money for when you’re of retirement age. What makes a 401(k) better than a normal retirement account? For one, you can put aside money directly from your pay before taxes are taken out of it. This reduces the income tax you have to pay right now.

For most people, it means that you sign up to have a certain amount of money withdrawn from your paycheck each pay period. This money will come out before taxes, as mentioned above. This means your paycheck will be a bit smaller than it otherwise would, but it won’t go down quite as much as the amount you withdraw (because your taxes will be smaller, too). So, if you sign up to have 10% of your check taken out, your gross income might go from $2,000 to $1,800, but your take-home might only drop from $1,700 to $1,530.

When you’re retired and go to take money from a 401(k) account, that’s when you’ll pay income tax on your withdrawals. In a way, you’ll be able to think of it as a normal paycheck coming out of your 401(k) account, as it’ll have taxes taken out of it.

Sometimes, employers will match what you have withdrawn from your check. If this is available to you, get every dime you can. This is free money. Yes, you don’t have access to it right now, but there’s no easier way to cause your retirement savings to skyrocket than to get every dime of matching you can.

Typically, a 401(k) plan offers a lot of different options for how to invest your money. This can seem overwhelming. Thankfully, there’s a pretty easy solution that works for most people. Just ask your investment advisor for a “target retirement” fund and put all of your money into that fund. Usually, there are several different funds of this type, each of which “target” a specific retirement year. So, let’s say you’re 25 and you want to retire when you’re 64. That’s 39 years from now. Since I’m writing this in 2011, that puts your retirement date at 2050. Thus, you’d want to put your money into a “target retirement 2050″ fund. These funds take care of things like rebalancing for you so you don’t have to worry about it.

A 403(b) is almost identical to a 401(k). Why the different name? Generally, 403(b) plans are offered at non-profit organizations and institutions of public education, whereas 401(k) plans are offered from businesses. A 457 plan is also similar, except it’s typically offered by governments.

An IRA is a retirement account that you can set up on your own, usually with an investment house like Vanguard. You have to make your own contributions to this plan, which is usually done via an automatic deduction from your checking account.

Contributions to an IRA are tax-deductible, which means that when you do your taxes, you can subtract the amount you contribute to your IRA from the total amount of income you’ll be paying income taxes on. For many people, this means a larger rebate check from the IRS.

As with a 401(k), when you make withdrawals from an IRA at retirement age, you have to pay taxes on those withdrawals as though they were normal income.

An IRA involves a lot more effort than a 401(k) for most people. You have to independently sign up for an IRA with an investment house. Once signed up, you’re going to have many more investment options than you would have with a 401(k), which is both good (options are good) and bad (lots of options can be overwhelming). As before, I typically encourage people to use a “target retirement” fund for all of their retirement savings if they’re unsure, which you can read about above in the 401(k) section.

OK, so what does Roth mean? A Roth IRA or a Roth 401(k) work similarly to the plans described above, except that instead of using pre-tax money, you’re using post-tax money for contributions.

How does that work? Your contributions come out of your take-home money in the case of a Roth 401(k), and your contributions aren’t tax deductible in the case of a Roth IRA.

Well, what do you get in exchange for that? All of the money you withdraw from these accounts at retirement is tax free. You won’t pay a dime of tax on any of it.

Naturally, this causes people to start asking questions like “is it better to pay taxes now or pay taxes at retirement time?” This is a debate that’s gone on for years and, frankly, there is no clear answer to it. My usual suggestion to people is to diversify. If you can, put some money into a Roth IRA or a Roth 401(k) and put some money into a regular 401(k) or a regular IRA.

A final note: what about FERS? FERS is essentially a federal pension plan available to federal employees. Many states offer a similar program with similar benefits to their employees. Typically, these plans offer a retirement pension based on years of service and salary and, typically, you don’t have to make any decisions after the initial sign-up.

Hopefully, this article helps you with the basics of various retirement plan options and makes it possible to navigate more in-depth articles about setting up things to cover your retirement.

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9 thoughts on “Help! I Don’t Know What Retirement Plan You’re Talking About!

  1. Mary says:

    Great article. This helps a lot, coming from a 25 year old who hasn’t even begun her retirement savings yet thanks to the economy. Next May I should have a stable job and will have the opportunity to start saving for retirement. I had no idea there were so many different options for this. So thank you!

  2. krantcents says:

    My wife and I max out 403B, IRA and Roth IRA. Having sufficient retirement savings is important. The one element I can not control is how long I will live. This the main reason I keep adding to our savings. I expect to live 30+ years in retirement.

  3. kristine says:

    Well… the other element you cannot control is economic stability. Retirement funds are only as safe as the eco-political system in which they are housed. Just ask any Argentinian.

  4. arvin says:

    This is something I’d always wondered about. So is it okay to have both an IRA and a Roth IRA? And do the contribution limits apply to both, or individually? As in the approx. $5000 limit, can I contribute 5000 to each of my IRA and Roth IRA, or will it need to be 5000 combined between the two?

  5. deRuiter says:

    Our rapacious politicians are looking for new sources of money. They are hungrily eyeing all that money piled up in tax deferred retirement accounts. There is a thought in Congress and the White House that perhaps this money could be taken over by the government to “manage”, (Social Security trust fund anyone?) and a suitable income given to you when you finally retire. The government spends money better than you and I do, like the million dollsrs recently spent in Kenya to teach Kenyan men to wash their penises (I kid you not!) after having sex, surely a better use for a million American taxpayer dollars than whatever those taxpayers would have spent the money on if they were allowed to keep it. I put my money in a post tax ROTH IRA as it is a little harder for our rapacious politicians to justify confiscating money on which the taxes have already been paid. Obama’s buddy got 585 million for Solandra which was known to be failing, other “green” projects like the car company in Finland (also an Obama fund raiser bundler involved there) got a similar sum to keep green jobs in Finland. If you can do a ROTH I suggest it as a slightly better chance at preserving your capital.

  6. Tom says:

    #4 Arvin
    You may have both, but the $5000 limit applies to total contributions. So you can’t put $5000 in a traditional IRA and $5000 in a Roth IRA.

  7. kristine says:

    de rutier- interesting. Though I am not like-minded poitically- I do see how a Roth would be safer from gov interference, as the taxers have already been taken out. They can up the taxes on a 401, but it would be harder to retroactively collect taxes from a previously taxed Roth.

  8. deRuiter says:

    I hadn’t thought of the retroactive taxing angle #7 Kristine, you’ve reinforced my satisfaction with my choice of a ROTH with a reason about which I never thought. Thanks! I’ve been uneasy about all the politicians speaking about the tremendous stash of money belonging to those with traditional (pre tax) retirement accounts. That bunch will stop at nothing to continue the spending free which enriches them and their relatives and cronies, and is the basis for their power. So many of the members of Congress and Senate are voted in and they have NOTHING. Yet when they retire with government pension and gold plated health care (no Obama care for them, they are exempt) they are multi millionaires.

  9. AnnJo says:

    deRuiter,

    Since money in 401(k)s and IRAs is already subject to taxation when it is withdrawn, the more likely route to confiscation would be indirect, such as a requirement that a certain % of the account be invested in government bonds – for the sake of “safety” and to protect you against market volatility, of course. (Poland was considering this route last year; I don’t know if they did it or not.)

    Another manipulation might be prohibiting investments in non-US companies, bonds or currencies. Argentina did something like this, along with nationalizing several private pension funds, in 2008.

    Financial investment transaction excise taxes or fees are another avenue. This latter proposal on a global level has had the UN salivating for a number of years now.

    Hungary last year gave people a choice: transfer their private pension funds to the State or lose 70% of their state pensions (equivalent to Social Security here), even though they would still be required to contribute to the state system.

    Unfortunately, Roth accounts are just as much at risk for such manipulations as any others.

    As long as government spending is set on autopilot to the “out of control” dial setting, it is naive to think there is any safe harbor from government taxation powers.

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