Finance 101: Retirement Plans

This Finance 101 topic will cover 401ks, 403bs and IRAs. We will discuss the meaning of these three common retirement plans, as well as the significant differences of each.

This Finance 101 topic will cover 401(k)s, 403(b)s and IRAs. We will discuss the meaning of these three common retirement plans, as well as the significant differences of each. City Girl Savings strives to emphasize the importance of saving for your future!

You may think that you are too young to worry about retirement, but this is something to think about at any age. Whether you are taking advantage of your company’s retirement benefits, or opening your own IRA, knowing what your options are can help you make the best choice for retirement saving.

401(k)

The first retirement plan we are going to discuss is the 401(k). A 401(k) is a retirement plan that is sponsored by your employer. This allows employees to place a percentage of pre-tax or after-tax (which we will discuss later) funds from their paycheck into the retirement account.

Taxes are not paid until the funds are withdrawn (typically at retirement). According to the Wall Street Journal, “401(k) plans, named for the section of the tax code that governs them, arose during the 1980s as a supplement to pensions.”

Pensions were originally managed by employers and were used to provide income throughout a person’s retirement. 401(k)s have replaced pensions in recent years, as the cost of running pensions has increased.

Most 401(k)s allow the owner to determine where the money goes. Typically users can pick from a variety of stocks, bonds and money market investments. Other options include target-date funds which allow for greater earnings as time goes by.

401(k)s are not intended for early withdrawals—there are strict taxes, fees, and penalties for using this money early. Some companies may offer the option to take out a loan against your 401(k), however the loan (plus interest) must be paid back to avoid early withdrawal penalties.

So how much should you contribute? Most companies will match employer contributions between 3-5%. This means that if 5% of your paycheck, totaling $150, is contributed to your 401(k), then your employer will match that 5% or $150.

This match will occur on every paycheck. With this being said, the minimum you should contribute would be the maximum employer match. For more, check out How Much Should I Save for Retirement.

Lastly, there are two types of 401(k) plans: Traditional (pre-tax funds) and Roth (after-tax funds). As discussed, traditional 401(k)s use money that has not been taxed. This is the standard option for 401(k) plans.

Another option is a Roth 401(k), which uses a contribution amount that has already been subject to state and federal taxes. This means that your traditional 401(k) will be subject to tax when you enter retirement. Also note that funds must remain in the account until the owner is 59 ½ years old.

With Roth plans, since money is already taxed, there are no taxes upon withdrawal. Owners have free access to these funds as long as the account has been open for 5 years. The maximum contribution amount for any 401(k) plan is currently $19,500 a year, as of 2021.

403(b)

A 403(b) is a defined retirement plan sponsored by your employer. It is usually offered by government or tax-exempt organizations, including schools, hospitals, and churches.

A 403(b) works the same way as a 401(k) plan. Employees of tax exempt businesses and organizations also have the option of contributing pre-tax or after-tax funds into a 403(b) plan.

The 403(b) plan has the same age requirements and penalty restrictions for withdrawing as the 401(k) plan. The maximum contribution amount for any 403(b) plan is currently $19,500 a year, as of 2021.

IRA

An IRA, or Individual Retirement Account, is an individual plan that allows users to save money for retirement with tax advantages. An IRA is set up at a financial institution and allows individuals to save on a tax-free or tax-deferred basis. There are three different types of IRAs: Traditional, Roth and Rollover.

A Traditional IRA is a savings plan that allows you to make contributions with money that you can deduct on your tax return, with the possibility of plan growth and earnings being tax-deferred until the money is withdrawn for retirement.

A Roth IRA is a plan that allows you to make contributions with money that has already been taxed. Similar to the Roth 401(k), a Roth IRA allows you to receive your funds tax free at retirement, as long as the account has been open for 5 years.

A Rollover IRA is an IRA opened with funds that were “rolled over” from a previous employer sponsored plan, like a 401(k) or 403(b).

So why invest in an IRA? According to Fidelity Investments, “Many financial experts estimate that you may need up to 85% of your pre-retirement income in retirement. An employer-sponsored savings plan, such as a 401(k), might not be enough to accumulate the savings you need. Fortunately, you can contribute to both a 401k and an IRA.”

An IRA’s most influential purpose is to be used in addition to a 401(k) or 403(b). It allows you to supplement additional retirement savings.

Per the IRS, the maximum contribution amount to an IRA is $6,000 a year or $7,000 a year if you are over the age of 50. If you contribute the maximum IRA amount with the maximum 401(k) or 403(b) amount, you could save a total of $25,500 a year.

If you start saving $300/month at age 25 and keep the same contribution amounts until age 65, you will have over $1 million in your account (assuming the historical 8% growth rate).

Okay City Girls, we have gone through the 3 most common retirement plans in the first of the Finance 101 series. We hope you can see the importance of saving for your future, as well as how simple it is to take advantage of any “free money” that can be contributed by your employer.

Make sure you have a solid budget in place to allow you to contribute a small percentage of your paycheck to your 401k. It is very important to get educated on how to save for your future so that you can live comfortably. Check out the City Girl Savings personalized budgeting portfolios to get your budget on track!

Related: 6 Ways to Secure the Bag for Retirement

We would love to hear about your views of 401(k) plans, or the different 401(k) benefits you have received thus far. Let’s empower each other! Share your feedback with us by leaving a comment below! Also, check out The Beginner’s Guide to Investing with Little Cash for more tips!

-The CGS Team