Detailed Explanations of
401ks are the most popular employer-sponsored defined contribution plans available. You can contribute up to $18,500 in 2018. In the case of a traditional 401k, your taxable income will be lowered by the amount you contribute for the current year. You can then withdrawal this money once you’ve reached 59 1/2 years old penalty free. At that point, it will be taxed as regular income, since you did not pay tax on it when it was invested.
There is also such things as a 401k Roth (since 2006) which mirrors the characteristics of a Roth IRA. The tax benefit in this account is treated differently. You pay your taxes now, but don’t have to pay taxes on the growth in the account later.
Essentially, this means, the money you contribute to a Roth 401k this year is money you’ve already paid taxes on, but once you turn 59 1/2, the money you withdrawal from this account, including the growth it’s made as an investment is all tax free to you.
Some 401ks have limited investment options. It depends on the way your company sets up their 401k plan. The average 401k plan has about 20 fund options. This differs from traditional brokerage accounts or even IRAs where you can hold a wide array of investments inside.
Individual Retirement Account (IRA)
IRAs differ from 401ks in a few important ways. One important point about IRAs and 401ks that many people don’t realize is, when considering how to invest, you should definitely have both. I do, although in my case it’s a TSP account (explained below) and an IRA. This is a key to maximizing the benefits of tax advantaged savings for retirement.
A traditional IRA refers to the IRA that has similar tax benefits to the 401k. The contributed money is taken as a tax deduction, but when the money is withdrawn after the age of 59 1/2, it is treated as taxable income.
If you do have an option for a 401k at work, you lose the tax deduction benefit on a traditional IRA once your income exceeds $72,000 ($119,000 if you’re married filing jointly).
Another difference between 401ks and IRAs is 401ks are administered through an employer, and IRAs are something available to anyone with earned income below the age of 70 1/2.
IRAs have significantly lower maximum contribution levels than a 401k. For 2018, the maximum is $5,500.
IRAs are similar to a normal brokerage account in that there are very little limits to what type of investments you can hold inside. 401ks and TSPs are limited in this regard.
Roth IRAs also exist and work the same way they do in a Roth 401k. Your after-tax dollars go into the Roth IRA, but when you withdrawal them after age 59 1/2, the original investment plus all growth is all tax-free income.
For a Roth IRA, you cannot contribute if your income exceeds $133,000 single and $196,000 filing jointly.
Thrift Savings Plan (TSP)
This is a defined contribution plan for United States civil service employees and retirees as well as for members of the uniformed services. It’s what I currently have instead of a 401k. This plan also has a maximum of $18,500 for 2018. There is also a Roth TSP option.
This plan is more limited in its investment options than an IRA or brokerage account. You have to invest in the funds they provide, but they pretty much cover the basic range of public traded debt and equity securities. They also do this with the lowest expense ratios I’m aware of, even lower than Vanguard. There main options are:
Government Securities Investment Fund (G Fund) – This is the only fund that is not invested in an index. It guarantees return of the investors principal, and has the lowest risk, but of course, also the lowest expected return. It pays an interest rate that is calculated on the current market yield of certain publicly traded treasury securities.
Fixed Income Investment Index Fund (F Fund) – This fund is a bond index fund. If you want to balance out your portfolio by investing in bonds to soften the risk of investing in the stock index funds, this is the fund you use.
Common Stock Index Investment Fund (C Fund) – This fund invests in the 500 large and mid-cap companies that comprise the Standard and Poor’s 500 Index.
Small Capitalization Stock Index Fund (S Fund) – A fund composed of the 4,500 companies outside the S&P 500 Index that make up the rest of the Wilshire 5000 Index, which is the broadest of the stock indexes. The C and the S fund combined at a ratio of approximately 4 to 1 make up the total stock market index.
International Stock Index Investment Fund (I Fund) – This is an index fund investing in companies outside the U.S. It mirrors the Morgan Stanley Capital International EAFE (Europe, Australasia, Far East) Index.