What the 401(k)?! The Top 5 Things You Need to Know About Retirement Plans

by Danielle Arlotta CFP®, Lead Planner

You have probably heard the advice to “invest for retirement.” You have probably also heard the terms 401k, Roth, and IRA– but what do they all mean? For the final iteration of our financial literacy month newsletter, we are reviewing the top 5 things you should know about retirement plans so you can save smarter. 

  1. IRAs: Roth vs. Traditional 

These terms reference the tax treatment, although the accounts are also titled this way.  A traditional IRA generally treats contributions as pre-tax income and the amount contributed becomes a tax deduction. Roth contributions are made after taxes, so there are no tax deductions in the year the contribution is made, but taxes are never again paid on the contribution or growth as long as IRS rules are followed. The idea is that in low income years, you want to contribute to a Roth and in high earning years, it is better to take the tax deduction by contributing to a traditional IRA.  

  1. A 401(k) is an employer-sponsored retirement plan.

If you are an employee and your company doesn’t offer a 401(k) or equivalent plan, you cannot contribute to one, unless you are self-employed (see #4). If you are a public sector or non-profit employee, you most likely have a 403(b), a 401(a), or a 457(b). These are all similar plans with similar characteristics, and a few detailed nuances. If your employer offers a match  and you contribute to the plan, they will match your contributions up to a certain amount. Look at your plan documents to see what kind of match your employer offers. It is usually listed in percentage or dollar amount form. Many employer retirement plans will allow you to make either Roth or Traditional contributions. 

  1. There are limits to how much you can contribute.

Contribution limits of most employer-sponsored plans are aggregated. This means if you have two jobs in the same year, you will need to make sure that you are not over-contributing to your plans. The 2023 limit is $22,500 for 401(k), 403(b) and 457(b) plans. Those 50 and over are permitted an increased “catch-up” contribution. For both Roth and Traditional IRAs, the total contribution limit in 2023 is $6,500 ($7,500 for those over 50). These are aggregate so if you contribute $1,000 to a Roth IRA, you can only contribute $5,500 to a traditional IRA. If you have access to a retirement plan at work you will not be able to deduct all of your traditional IRA contributions if you make over $73k and file as single. For Roth IRAs, your income as calculated by MAGI or Modified Adjusted Gross Income on your tax return has to be below $138k if you file as single to make a full contribution. The IRS website lists out the limits for all of the above situations.

  1. There are options if you are self-employed!

Yes, you can open a Roth or Traditional IRA, but there are options that allow you to save even more. The most common self-employed retirement plan options are SEP IRA, SIMPLE IRA, and a solo 401(k). How much you can contribute to the above plans will depend on your total income for the year. If you have employees there are also rules around if and how much you need to contribute for them. If you work for a small business, you also might have one of these plans.

  1. You need to invest the money you put into your retirement plan. 

Most employer-sponsored plans will include a “target date” investment fund based on your retirement age. When we work with clients, we prefer to use individual lower cost funds, but for DIYers, these funds are generally diversified and have an allocation of stocks to bonds that will become more conservative as time goes on. If you open an IRA or self-employed retirement plan, you’ll need to select how it’s invested. If you rollover an employer retirement plan into an IRA, you will also need to invest the money once it is in the account. 

Next steps:

  • If you have an employer retirement plan, make sure that you are contributing up to the maximum amount your employer matches.
  • If you do not have an employer retirement plan, consider opening an IRA. 

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