Types of 401(K) Plan – How To Choose

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A pension plan in advance will make retirement life easy and comfortable. Let’s talk about pension plans before explaining the types of 401 (K) Plan.

Types of pension plans

There are two popular types of pension plans.

Defined Benefit Pension Plan ( DB)

DB plan refers to the employer-led pension plan. Employees who retire or lose their employability shall determine the fixed amount of retirement subsidy according to their working years, posts and other factors. It is usually paid monthly until the death of the beneficiary.

Company will assume and control the investment risk and portfolio management. Such pension plans have certain limits on the time and form that employees can withdraw the amount without paying the penalty, and the employer needs to record the assets and liabilities on the balance sheet.

Defined Contribution Pension Plan (DC)

DC plan means that both the company and the employee deposit a certain amount of money in the retirement account. The risk and portfolio management of investment are borne by the employee himself, so the value and return in the future are uncertain. For companies, pensions do not recorded on the balance sheet. They recorded in the income statement as expenses.

For most of the companies now, generally adopt the defined contribution plan, so the profits and losses of investment are still at some risk.

Types of 401(K) Plan

Many of you may find that your company offers several options for your 401(k) Plan. So how do you choose?

In fact, the difference between 401(k) plans is mainly reflected in taxes. There are three common choices:

Traditional 401(k) Plan (pre-tax)

This is the most common type of Plan. You don’t have to pay taxes when you save money, but you may have to pay duty when you withdraw money after retirement. The problem that needs to pay attention to is, the money that takes money when retiring is the money that obtains deposit and investment income, so when paying taxes also is the tax that pays principal and income sum correspondence.

For more details about paying taxes, check out posts 401(K) Plan – What It Is and 401(K) Plan – Questions And Answers.

Roth 401(k) Plan

Unlike the previous Plan, Roth 401(k) plans pay taxes when you save money. But investment income is not taxed. So after you retire, you don’t have to pay any taxes when you withdraw money at all.

After-tax 401K Plan

This is a popular Plan in recent years, but not all companies have this kind of Plan. First of all, there is a big difference between this plan and the two plans above: the annual limit on savings. For example, both Traditional 401K and Roth 401K contributions upper limit in 2019 are $19,000. The total amount you and your employer can contribute to a 401K account is capped at $56,000. But for an after-tax 401K plan, your individual contribution upper limit is $56,000. You can save more money all at once.

However, unlike Roth 401(k) plan, after-tax 401K contribution plan is not exempt from the tax on investment income. But he tax on investment income can be deferred, so it has some advantages.

FROS and CONS of different plans

Each of the above three 401(k) plans has its own advantages. Let’s first compare traditional 401(k) plans with Roth 401(k) plans.

Roth 401(k) Plan

The benefits of a Roth 401(k) Plan are the ability to deposit more money each year than a traditional 401(k) Plan. From the perspective of IRS policy, the upper limit of Roth 401 (k) Plan and traditional 401 (k) Plan is the same. But a Roth 401(k) Plan is a taxable deposit, there is actually more money in a retirement account than in a traditional 401(k) Plan.

When you reach age 59.5 and can withdraw your retirement account without tax, the Roth 401(k) Plan can be withdrawn in full, with no additional costs. But a traditional 401(k) Plan account requires a reasonable choice of withdrawal time. Because your annual income will include the amount withdrawn from the traditional 401 (k) plan. Withdrawing large amounts of money at once leads to higher tax rates, which runs counter to the purpose of the 401 (k) plan.

For young people who have just started working, it is very suitable to participate in Roth 401(k) Plan if the current income is not very high and the tax rate is relatively low but the income will expect to increase in the future.

Traditional 401 (k) plan

Annual income does not include the amount deposited in the traditional 401 (k) plan. And many of the deductions base on the current year’s Adjusted Gross Income (AGI). So participation in a 401(k) Plan may allow you to either enjoy additional deductions or avoid additional taxes. A Roth 401K does not have the same benefits as a traditional 401(k) Plan.

After-tax 401(k) Plan

After-tax 401(k) Plan is largely unmentioned. It seems that an after-tax 401K Plan may have the least helpful for tax benefits compared to both other plans. So what are the benefits of an After tax 401(k) Plan? The benefit is that the annual savings ( $56,000 in 2019) can be converted into a Roth account. And Roth account investment income is not taxable!

Some of you may have noticed that I was talking about possible conversion to a Roth account. So, who can convert? Only the company that allows Inservice Transfer can be transferred! There are some companies that allow you to transfer your after-tax contribution to a Roth account while on the job. If you do the following three:

  • Choose an after-tax contribution plan when annual adjustment of 401K.
  • Open a Roth account at the same time.
  • Transfer your after-tax 401(k) plan to your Roth account immediately.

The future investment income of the money will not need to be taxed!

For more on 401 (K) plans, check out Wikipedia.

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