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Tax-deferred retirement plans: Everything you need to know

At a glance:

  • How to contribute to a tax-deferred retirement plan 401k, 403b, or 457 plan

  • What you can contribute

  • Defined benefit pension plans

  • What are IRAs?

  • Summary of tax-deferred retirement plans

  • Practical ideas you can start with today

At first glance, a list of common employer retirement plans may read like an alphanumeric soup — IRA, 401k, 403b, and so on. Yet understanding the basics of these plans is not difficult and can help you plan wisely for your future.

Knowing how you and your employer may contribute to these retirement plans can help you evaluate a job offer, take full advantage of your retirement plan options, and make wise decisions about your future.

How to contribute to a tax-deferred retirement plan 401k, 403b, or 457 plan

If you have a 401k, 403b, or 457 plan, here is how contributions work.

Both employers and employees may contribute to a plan. Contributions typically come out of the employee's gross pay (they are called "elective") and may be matched by the employer (but are not required). The maximum allowed contribution may rise from year to year, being indexed to inflation, and extra "catch-up" contributions for people beginning in the year that they turn 50 years old.

Matching contributions are contributions that an employer makes to an employee's plan after the employee has contributed. For example, assume the employer agrees to match 50% of the employee's first 10% deferral. In such an instance, if the employee deposited 10%, the employer would add an additional 5%. The total percentage deposited for the employee therefore would equal 15%.

The performance of your plan will depend on the performance of its underlying investments.

What you can contribute

401k plans: The maximum employee contribution is $19,500 for 2020. Taxpayers over age 50 can contribute an additional $6,500.

Total contributions (employee and employer) are limited to the lesser of 100% of the employee's compensation or $57,000 for 2020.

403b plans: Generally, an employee can elect to defer up to $19,500 for 2020. Those over 50 are entitled to a "catch-up" of $6,500. However, both elective deferrals and employer contributions may not exceed the lesser of $57,000 in 2020 or the maximum amount contributable.

457 plans: For 2020, you can contribute up to $19,500. Any future increases will be indexed to inflation. This contribution amount applies to both governmental and non-governmental plans. If you are 50 or over, you can contribute an additional $6,500 per year. But these catch-up contributions are only allowed in governmental plans.

For 457 plans, there is an additional catch-up contribution (called the "three-year catch-up") that is available only to employees who are within three years of their plan's normal retirement age. This type of catch-up is available to both governmental and non-governmental plans.

Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)
Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)

Defined benefit pension plans

In a defined benefit pension plan, an employer commits to paying its employee a specific benefit for life beginning at his or her retirement. The amount of the benefit is known in advance and is usually based on factors such as age, salary, and years of service.

For 2020, the maximum retirement benefit permitted under a defined benefit plan is $230,000. Defined benefit plans do not have contribution limits. Contributions are made by the employer and, in some cases, the employee as well.

Contributions from the employer — and sometimes from employees — are put into a fund set aside to pay the benefits. The fund is reviewed by actuaries yearly to ensure that it will meet payments to retirees.

What are IRAs?

Individuals can set up their own accounts for retirement through individual retirement accounts (IRAs), either the traditional variety or the Roth variety. They can set them up in a variety of investments.

Individuals must have earned income in order to contribute to individual retirement accounts. Earned income is income from employment, as opposed to earnings from one's investments. Individuals must open an IRA account with a custodian such as a bank, credit union, or investment firm.

After selecting a custodian, an individual must deposit cash into his or her investment of choice. The largest contribution allowable for 2020 is the smaller of $6,000 or 100 percent of earned income.

The IRS has very specific rules regulating the contribution amounts and deductibility. It also has rules regarding withdrawals and when they can be made and how they are taxed. IRAs are an excellent way to save for retirement, but you should be aware of the rules, benefits, and drawbacks.

Traditional IRAs

The money contributed to a traditional IRA may be tax-deductible, depending on your income and whether you participate in an employer-sponsored retirement plan. The income the account earns is not taxable while it is in the accounts.

Contributions that are deductible will, however, be taxed when money is withdrawn from the account.

For 2020, a married couple in which both spouses work may contribute up to $12,000 in total, with $6,000 in each account (or 100 percent of earned income, if it is less). A person may make an additional $1,000 contribution beginning in the year that they turn 50 years old.

There are different ways to save for retirement. (Photo: AP Photo/Pat Eaton-Robb)
There are different ways to save for retirement. (Photo: AP Photo/Pat Eaton-Robb)

Roth IRAs

As in the traditional IRA, the most one individual can contribute to a Roth IRA for 2020 is $6,000. This limit is $1,000 higher for individuals age 50 or older. The most a married couple filing taxes jointly can contribute for 2020 is $12,000 ($6,000 each). These limits rise to $14,000 ($7,000 each) beginning in the year when individuals turn 50 years old.

How much one may contribute is limited for those above certain income levels. Contributions are not tax-deductible. However, withdrawals are not taxed when all rules have been properly followed.

You may simultaneously contribute to a traditional IRA, as long as the total placed into both accounts does not exceed the yearly limits.

You may make contributions for a particular year up until April 15 of the following year (unless that date falls on a weekend, in which case it will be extended). You must mark on the contribution form the year for which the contribution is made.

Summary of tax-deferred retirement plans

Over the course of your working life, you may participate in a variety of retirement plans. While each plan has somewhat different rules — in the amounts and types of contributions permitted — all share several positive attributes.

Employer plans offer higher tax-deductible contributions than individual retirement accounts (IRAs), for example, and they enable an employer to contribute toward the retirement needs of employees, making retirement planning easier for many people. Understanding how each plan can contribute to your retirement goals helps you ensure the future of your dreams.

Practical ideas you can start with today

  • Maximize your employer match.

  • Estimate how much your existing plan will be worth at retirement.

  • If you don't already have one, contact your payroll and benefits department to inquire about opening an employer retirement plan.

  • Open up a 401k, 403b, 457, defined-benefit, or individual retirement account plan to begin saving for retirement.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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