Workplace Retirement Plans: Explained

Have you ever looked at one of your 401k statements and tried to decipher what you were looking at? Have you ever received information on a new 403b plan and wondered what to do with it? If any of these questions pertain to you, keep reading!

There are many different types of retirement plans depending on the type of employer you work for (think: 401k, 403b, 457b, 401a, SIMPLE IRA), but they all have the same basic ingredients. Each offers a variety of investment choices, either the ability to contribute by percentage or dollar amount, Pre-Tax/Roth/After-Tax contribution options, maybe an employer match, the list goes on. I will highlight the main features and also help you determine how to take advantage of this benefit regardless of the type of plan you are enrolled in.

Investment Choices

It may seem overwhelming to see a list of 30 mutual funds and figuring out which are best for you. Mutual funds are by far the most common options (employer stock is second). Speaking of stock, putting all of your money into your employer’s stock is very risky and should be avoided. Remember Enron? At most you could allocate 20%, but the better benchmark is closer to 10%.

Okay back to mutual funds… A mutual fund is a “basket” of stocks and/or bonds, depending on the objective of the fund (more on that in a minute). If you are younger, you may be able to get away with a much higher percentage of stock-based mutual funds than someone who is older and has less time to retire. This is because stocks tend to be riskier (more extreme highs and lows) than bonds. The idea is to diversify your selection to small, medium, and large domestic (U.S.) and international companies. In the bond category, you may see short, medium, or long-term durations, and perhaps inflation-protected or even high-yield bonds (better known as junk bonds because of their lower rating, but higher interest rate). Sometimes an employer offers real estate or sector-driven funds such as tech, energy, or healthcare, but these can be even more volatile because they are more focused (less diversified). That may be okay when you’re young and have time on your side, but probably not for a 58 year old retiring in 5 years.

The percentage you put into each of these funds can be another challenge. First, you will want to know your tolerance for risk and risk capacity (timeframe) before you do this so you aren’t too risky or not risky enough. Questionnaires can be found online and they will recommend a model portfolio that can give you an idea of how much to put in stocks vs bonds. This may not be detailed enough, however, so consulting with a retirement or financial advisor can help you with this as the questionnaires may only tell one story.

So, if you don’t like the idea of picking and choosing individual funds, you may be able to opt for a target/retirement date fund. These are “one stop shop” funds that combine several mutual funds into one (already diversified) and work towards a particular year. The later the year, the more it invests in stocks. The closer you get to the year, the less risky it becomes. Simply take your best guess on when you may need to use the money (usually retirement), and you’re off!

Contribution Options

You may have seen the option to contribute Pre-Tax (traditional), Roth, or a lesser known option called After-Tax. You may only have one of these or all of them. It depends on how your plan is set up. If you only have one option, the answer is simple. If you have two or more, the decision becomes more difficult. By the way, if your employer matches, their contribution is always pre-tax.

Why choose Pre-Tax? Every dollar you put into pre-tax simply means that the money goes in before tax and lowers your taxable income by that amount. This is usually beneficial for someone in a higher tax bracket who wants to lower their income in order to owe less in taxes. Or, it could be for someone who thinks their income and taxes will be lower in retirement because the money will be taxed when it is withdrawn in the future.

Why choose Roth? Every dollar put into Roth means the money has already been taxed, so there is no up front tax benefit. The tax benefit is on the back-end when you withdraw. Since the money has already been taxed, it will not be taxed in the future assuming the withdrawal is qualified. There are some exceptions, but that is another day! You may want to contribute Roth if you do not have a current tax "problem" and/or expect to be in a higher tax bracket in retirement.

Why choose After-Tax? Although more rare, after-tax contributions can be very beneficial, particularly for high income earners. While the money goes in after tax (creative, huh?), it is different than Roth. Even within an employer retirement plan, after-tax contributions (not earnings) can be withdrawn tax-free. In addition, if you have maxed out your contribution ($19,500 for 2021 if under age 50), you can put additional money in after-tax, not to exceed the aggregate employee/employer limit ($58,000 for 2021 if under age 50). If you are over age 50, you get an additional $6,500 under each limit. *These funds can later be converted to a Roth IRA or via an in-plan conversion if your employer allows. Otherwise, known as a Mega Backdoor Roth. For those over the income limits to contribute directly to a Roth IRA, this conversion option is a huge benefit.

*The conversion option is on the table in Congress to be eliminated in January 2022. No decision yet as of this writing.

You also may be able to mix and match the above if you have more than option. If you aren't sure which is best, consult with a tax or financial professional before making your choice.

Percentage or Dollar Amount?

If you have the choice, choose percentage. Why? As your income increases, so does your contribution. Some employers may even offer an auto-escalation feature where you can specify you would like your contribution to increase by 1% each year. I don’t know about you, but the less thought I need to put into something, the more likely I am to do it and most importantly, stick with it.

Who Should Contribute (and How Much)?

Well, everyone should contribute at least enough to get the employer match, if offered. It is free money. After that, it depends, of course. Some folks may have IRAs, Roth IRAs, and taxable brokerage accounts. Depending on the investment options (or lack thereof) and fees within your plan, contributing additional money to an outside account may make more sense, particularly if you want to buy ETFs, individual bonds, or stocks. Also, pay close attention to the expenses within your plan (check out the Summary Annual Report). Administrative fees and high mutual fund expense ratios can eat away at your returns. Index funds tend to be less expensive because they follow an index (think S&P 500) and are not actively managed.

Summary

At some point in our lives, most of us will have the option (or be required) to participate in a workplace retirement plan. You will be faced with many options, including how much to contribute, how to contribute, and what to invest in. There may also be options such as loans and hardship withdrawals, but these should be used sparingly and only in emergencies, if at all. Also, pay attention to the rules for withdrawing the money and any associated penalties. The goal is to keep your account invested as long as possible and for it's intended purpose: retirement.

Mistakes can be made, such as not investing enough to meet your goals, not taking enough or too much risk, paying too much in fees, etc. These mistakes can be detrimental to your retirement plan. Be informed! Your employer may offer a retirement advisor or you can consult with an independent financial planner to help you with your specific situation and plan. If you have questions, do not go at it on your own. Find a professional and get your retirement plan on track!