MM005: Understanding Retirement Accounts: Traditional 401(k)
You've heard of 401(k)s at work, and heck you might (hopefully!) contribute to one. But do you really know how they work and how they can maximize your retirement savings? Let's dive in and learn more about the Traditional 401(k) account.
IN THIS WEEK'S EPISODE
* Understanding the basics of a Traditional 401(k) account
* How do contributions work for a Traditional 401(k)?
* Breaking down the ins-and-outs of how a Traditional 401(k) works in retirement
* How you can track management fees for your retirement accounts with Personal Capital
* An example scenario of how a Traditional 401(k) beats investing in a taxable account
* Explore the limitations of a Traditional 401(k)
* Why management fees are the silent killers of retirement accounts
Understanding Retirement Accounts: Traditional 401(k)
Before we dive into the Traditional 401(k), let’s set the table first.
There are four primary types of “defined contribution plans,” or plans offered through an employer:
* 401(k)s are the version that corporations offer to their employees.
* 403(b)s are for employees of public education entities and most other nonprofit organizations.
* 457s are for state and municipal employees, as well as employees of qualified nonprofits.
* Thrift Savings Plans (TSPs) are for federal employees.
I’m not as familiar with 403(b)s, 457s and Thrift Savings Plans, and we’re not going to cover those here, so if you have experience contributing or withdrawing from these accounts, I’d love to hear from you on your experience.
There is also another type of retirement account, the IRA, which stands for Individual Retirement Account. As the name implies, it’s a retirement account for individuals. It was created as an alternative to those who didn’t otherwise have access to a defined contribution plan at work. This would allow a small business owner or entrepreneur who didn’t set up a formal 401(k) to still contribute to their retirement. It might also be used as a supplemental retirement vehicle for those who also contribute to a 401(k). We’ll cover IRAs in a different episode.
Then there are 401(k)s, which are what most people are familiar with and what we’re going to focus on today. They are retirement savings accounts that are set up and managed by your employer, or more accurately through a custodian that they assign to manage the account. This could be through Wells Fargo or a local investment advisor. They’re the one helping manage your retirement savings and those of your co-workers.
Within 401(k)s, 403(b)s and IRAs, there are two types of each: traditional or Roth, with key differences between the two types being when you pay taxes on the money. With a traditional account, you don’t pay income taxes on the contributions you make during your working years and pay income taxes in retirement on whatever you withdraw from your retirement account each year. A Roth account is the inverse; your contributions are all made with post-tax dollars, which means that you’re able to contribute less than a traditional account but in your retirement all of your gains are tax-free. Sometimes you have a choice, sometimes you only have one option, but it’s always important to know the differences between the different types of accounts so you can make an informed decision when you have a choice, depending on your situation.
The Skinny on the Traditional 401(k)
The 401(k) as we know it was almost accidentally created. The Revenue Act of 1978 was an answer by Congress to the pressures they were under from high-worth individuals that were looking for a tax shelter for their money. A guy named Ted Benna came across an obscure section of the Revenue Act,