Stashing money in tax-advantaged retirement accounts is an easy way to boost your effective salary. It is almost always to your great advantage to put as much money as you can reasonably afford into these accounts if they are available to you. But with all the nomenclature, they can be a bit confusing. 401, 403, 457, a, b, k, base, supplemental…what’s an investor supposed to do? The IRS wanted it to be very clear what each of these accounts was for so they decided to name them after the section of the tax code that describes them. Obviously.
In the end, these accounts are all relatively simple. They save you $’s if you are willing to put off spending your paycheck for a while. Sometimes a great while (but always a great amount of $’s). More technically, they are a way to defer paying taxes on your income for a period of time. This is important for a couple of reasons. One, you get to invest more money, which will increase your long term gains. Two, you are likely to owe less tax on the income in retirement than you would if you were to take the income now. You still have to fork over the same medicare and social security regardless of what you contribute, but you can save a boatload on the rest. So, what are these mysteriously named accounts?
401(k), and 403(b)
These days, these accounts are basically the same thing. The 403(b) is for tax-exempt organizations, like hospitals and schools, while a 401(k) is used by for-profit organizations. 403(b)’s usually vest immediately, while you may need to wait for a 401(k) to vest. When the account is “vested” that means it belongs to you. This only applies to amounts that the employer contributes; money you contribute is always yours.
The total contribution limit for these accounts is $18,000 ($24,000 if you are over age 50) in 2016. Anything that goes in has to stay there until you are 59.5, or there is a 10% early withdrawal fee (there are some special ways of getting around this if need be).
Some employers use 401(a) accounts for the employer contributions to your retirement. This account wouldn’t contain any funds that came from your paycheck. Any amount contributed to this account does not count toward your contribution limit for the year. The withdrawal rules are the same as the 401(k) or 403(b).
This account is a different type of beast. It’s not technically a retirement account but a deferred compensation plan. The total contribution limit for the 457(b) is $18,000 ($24,000 if you are over age 50) in 2016, and this is in addition to the 403/401 limit if you are lucky enough to have both. The 457(b) is pretty sweet because you can start withdrawing from this account as soon as you stop working for your employer with no 10% early withdrawal fee. The means if you are retiring early, the 457 can bridge you from retirement until you reach age 59.5 when you can tap your other retirement accounts.
If you have access to one of these plans through an employer, chances are you have access to multiple versions, which means your retirement dollars might be funneled into 3 or more different places. At the hospital where I work, I have a 401(a), 403(b)-base (the part of my contribution which is matched), 403(b)-supplemental (unmatched contributions), and a 457(b). They are all made up of exactly the same funds, which makes them easier to manage.
How you can save a pile of cash
Money you invest in these retirement accounts would have otherwise been taxed at your marginal rate. If that’s 25%, you will have a whopping 33% more $’s invested than you would have if you had just invested the money in a regular taxable account, no matter what rate of return you get. It may even be more than that considering the fact that your retirement dollars get siphoned off your paycheck before you can even touch them, so it’s basically forced savings. Yes, you still have to give the government its cut when you withdraw the money in retirement, but considering the fact that your income will probably be much lower then, you might even get away with not paying anything depending on your situation.
How much should I put in??
As an example, the two income earning members of the Paradise Family (Apollo and Cucumber contribute by acting as pseudo-heating blankets), both stash $36,000 per year. With company matches, our retirement contribution reaches about $94,000 annually. There are only a few reasons why you wouldn’t want to take advantage of this to the maximum extent possible. One reason would be if you don’t have access to a 457k, and you won’t have enough additional savings to bridge you to age 59.5. Another reason would be if the fund choices in the accounts are no good, in which case you should petition your employer for something better! In any case you should always contribute enough to get the entire company match. This is free money, don’t leave it on the table!
Okay, how do I do it?
This part is very easy. Call your benefits department and tell them how much you want to contribute each month. They should prevent you from contributing too much if you make a math mistake. The simplest way to contribute is to take a fixed amount out each month, but there are also some benefits to front-loading, e.g. stashing your entire paycheck at the beginning of the year until you reach the max. Mad Fientist had a great article about the advantages of front-loading. If you choose to go this way, make sure that you aren’t missing out on any of your company match. Some employers will only match a fixed max percentage of your contribution each month. In any case, plan in out and decide what’s best for you. You won’t regret it!