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When Americans think retirement savings, they think 401(k).

The 401(k) is a big deal because it offers similar tax advantages as the IRA, but with a much higher annual contribution limit: in 2014 you can contribute $17,500 to a 401(k), over 3x the $5,500 you can contribute to an IRA. Like the IRA, the 401(k) comes in two flavors: Roth, where you choose to pay taxes now, and Traditional, where you choose to pay taxes later.

A 401(k) is funded with paycheck withholding: you elect to invest a certain portion of your paycheck directly into a 401(k) in such a way that you never 'see' the money in your bank account. For many people, paycheck withholding is less psychologically painful than contribution from a bank account.

In the best news of all, many companies encourage employees to contribute to the company 401(k) by offering a company match: if you contribute to your account, the employer will match your contributions for free. If this is available to you, take it—it's free money!

Making The Most of Your 401(k)[edit]

  1. Determine if you're eligible for employer matching contributions
  2. Survey your investment options
  3. Don't neglect your Roth IRA
  4. Practice tax-efficient asset placement
  5. Receive a raise? Contribute it!
  6. Consider consolidating old employer plans

401(k) Lifecycle[edit]

The IRA is very simple:

  • you transfer money in from your bank account
    • if a Traditional IRA, your taxable income is reduced
  • the money grows; you pay no taxes
  • you withdraw the money you put in; you pay no taxes
  • you withdraw the earnings
    • if a Roth IRA, you pay no taxes
    • if a Traditional IRA, you pay income taxes

The 401(k)'s lifestyle will look quite

  • you transfer money in from your paycheck
    • if a Traditional 401(k), your taxable income is reduced
  • the money grows; you pay no taxes
  • you withdraw the money
    • if a Roth 401(k), you pay no taxes
    • if a Traditional 401(k), you pay taxes

But there are other possible fates for a 401(k)!

  • Rollover: 401k → IRA (no longer working for the company)
  • In-Service Rollover: 401k → IRA (still working for the company)
  • Roth Conversion: 401k → Roth 401k
  • Roth Conversion: (401k) → IRA → Roth IRA

401(k) Downsides[edit]

Many articles have already cataloged the failures of the 401(k):

How 401(k)s are failing millions of Americans (The Week, 2012.04.20)

11 Things About 401(k) Plans We Need To Fix Now (The Huffington Post, 2014.03.21)

The Greatest Retirement Crisis In American History (Forbes, 2013.03.20)

Problems with Matching[edit]

Many companies try to discourage employees from leaving by delaying vesting on employer matching contributions. This means that you only own the matching money if you stay at the company for a certain amount of time after the matching contribution was made, often a year or more. If you leave earlier, you must forfeit the matching contributions.

Many employers also make the matching contribution in company stock. Company stock is not diversified, and it's a very bad idea to have your job and your retirement savings dependent on the company's future. If your employer makes matching contributions in company stock, dump that garbage immediately and reinvest the money in a low-cost index mutual fund.

Disadvantages Versus the IRA[edit]

You can't make penalty-free pre-retirement withdrawals of principal from a Roth 401(k) like you can from a Roth IRA. Unlike the wide-open investment options offered by an IRA, your options are usually restricted to the mutual funds chosen by the 401(k) management company, which may be low-quality and have high fees.

You Have To Set It Up[edit]

You have to decide how much to contribute and what to invest in. If you continually procrastinate and never manage to fill out your company's 401(k) paperwork, you'll never contribute any money to it. Many employees never overcome this activation barrier.

This is easy enough to remedy by taking the initiative. If your employer offers a 401(k) plan, it is your responsibility to set up contributions. March straight down to HR, get that paperwork, and get your contributions started!

Do People Take Advantage?[edit]

The Employment Benefit Research Institute (EBRI), which tracks statistics concerning employer-sponsored plans like the 401(k), estimates that investments in 401(k) plans accounts for one-fifth of the $18 trillion in US retirement assets in 2011. The Investment Company Institute has similar numbers for 2012: 50 million Americans had piled $3.5 trillion into 401(k) plans as of September 2012. For context: the entire gross domestic product (GDP) of the US was $15.7 trillion, and all of the retirement savings in the entire US were around $19.4 trillion. (If you want to know everything there is to know about retirement savings in the US, you can find it in these sites!)

Unfortunately, half of the working population doesn't have access to a 401(k)! Of those that do, many contribute little or nothing.

Early Retirement and the 401(k)[edit]

If you're planning on retiring early, having 'enough' money is only half of the battle: the money must be accessible for withdrawal in the amounts and at the times you need it. An important part of retirement planning is ensuring that your money pipeline is full—that you will always have sufficient withdrawal capacity to cover your expenses (plus a margin of safety).

With the Roth IRA, you could withdraw the total amount that you contributed—the principal—at any time and for any reason without taxes or fees. This is not so with the 401(k)! You must reach age 59.5 before you can withdraw money from a 401(k) without paying an early distribution penalty, regardless of whether it's a Traditional 401(k) or a Roth 401(k). This poses a challenge: covering your expenses from retirement until you can tap into these accounts at age 59.5.

By planning ahead, it's possible to convert a 401(k) into a Roth IRA with a combination of rollovers and conversions.

401(k) Conversion: 401(k) → Roth 401(k)[edit]

via Reuters:

"As part of the American Taxpayer Relief Act of 2012, Congress made it possible for all retirement savers to convert their 401(k) accounts to a Roth 401(k) without moving money out of the workplace plan. The law permits all retirement savers to convert existing 401(k) retirement plan assets to a Roth 401(k), so long as their plan offers Roth options and adds the conversion feature. Previously, conversions could be done only by savers who also were eligible to take a distribution from the plan -- in most cases, people age 59½ or older."

To carry out a Roth 401(k) conversion, you simply pay tax on a portion of your current Traditional 401(k) holdings to convert them into a Roth 401(k). You can do this while you're still working, and it's perfectly fine to convert only some of your holdings[1][2].

With a Roth 401(k) conversion, you choose to pay tax on your retirement savings now instead of later. This is advantageous if you expect to be in a higher tax bracket in retirement than you are now, either due to increases in income or to increases in US federal tax rates. Fairmark has an excellent guide on 'designated Roth accounts' like the Roth 401(k).

But it still doesn't solve the problem with your money pipeline: you can't touch the converted Roth 401(k) money until you reach age 59.5. To get at your money sooner, you'll need to perform a rollover to convert your 401(k) into an IRA.

401(k) Rollover: 401(k) → IRA[edit]

If only you could turn that Roth 401(k) into a Roth IRA, then you could withdraw the Roth IRA principal whenever you needed it without triggering taxes or fees! With a 401(k) rollover, this is possible.

When rolling over a Roth 401(k) into a Roth IRA, the following rules apply:

  • "the years of participation in the designated Roth account don’t count toward the five-year requirement to take tax-free distributions from a Roth IRA." This means that you must perform the 401(k) → Roth IRA rollover at least five years before you want to withdraw any earnings from it without paying a penalty!

Fairmark provides an example to illustrate how this works:

"Over a period of six years you contribute $65,000 to a Roth 401k account. Then you leave that company and roll the entire account, worth $100,000, to a Roth IRA.

Even though you’ve had the Roth 401k account more than five years, this is a nonqualified distribution if you aren’t over 59½ or disabled. In that case you would get $65,000 of basis in your Roth IRA. You would be able to withdraw up to $65,000 tax-free any time you want. To withdraw more than that amount tax-free you’ll have to wait five years (and be over 59½ or disabled)."

There is a positive caveat to the above:

  • "Although you don’t get to count the years you held the Roth 401k before the rollover, you do get to count any time you held a Roth IRA. For example, if you held a Roth IRA three years before the rollover, you would only have to wait two years after the rollover to meet the five-year requirement." As long as you have an old Roth IRA lying around, the 5-year rule doesn't pose a problem!

Rollovers and Taxes[edit]

This site has a great description of the rollover tax consequences:

"When you leave a job where you have a retirement plan, like a 401(k) or 403(b), you can roll over all or a part of it into an IRA. This is generally recommended—unless you have a great reason to leave money in your ex-employer’s plan, like an extensive menu of low-cost investment choices. Rolling over funds from a traditional pre-tax workplace retirement account into a traditional IRA is simple because you don’t have to pay income tax or penalties (as long as you complete the rollover within 60 days). It’s also clear-cut if you roll over from a post-tax Roth 401(k) or 403(b) into a Roth IRA.

However, rolling over funds from a traditional retirement account into a Roth IRA means you must pay income tax on any amount that wasn’t previously taxed."

Rollover Roth IRA Withdrawal Rules[edit]

Once again, this site has a great run-down of Roth IRA withdrawal rules:

"With a Roth IRA, taxes and penalties for distributions depend on whether you’re withdrawing original contributions, rollover conversions, or earnings—and on how long you’ve owned the account. To withdraw rollover conversions without taxes or penalties, there is a 5-year waiting period that starts on January 1 of the tax year you convert."

Undoing a Roth Conversion[edit]


Roth IRA Reconversion to Reduce Taxes @ Fairmark]

"Any amount that was converted to a Roth IRA and then switched back to a traditional IRA in a recharacterization can’t be reconverted in the same year as the original conversion, and also can’t be reconverted within 30 days of the of the recharacterization. But there are still some valuable planning opportunities for people who suffer market losses after a conversion."

"If you do a partial conversion, you have greater flexibility in undoing a conversion and (effectively) redoing it. That’s because the rule delaying the reconversion only applies to the amount that was originally converted. It doesn’t apply to an amount that wasn’t previously converted."

IRA Recharacterization references:

Designated Roth Accounts[edit]

Thrift Savings Plan Research http://goo.gl/G1JV8G

"This section references both the Roth 401(k) and the Roth TSP. This is because the Roth TSP and Roth 401(k) are both classifed by the IRS as ‘Designated Roth Accounts’, and therefore many of the same rules and procedures apply."

The 401(k) Rollover[edit]

IRA rollovers do NOT reduce your IRA contributions for the year.

"Rollovers and Roth IRA contributions" via: http://www.bankrate.com/brm/news/DrDon/20061227_rollover_IRA_contribution_a1.asp

question: "does the $2,000 conversion count against the $4,000 contribution limit for 2006? Or can I still contribute an additional $4,000 on top of the amount already converted?"

answer: "The crux of your question is whether rollovers limit contributions. They don't. According to Internal Revenue Code (IRC) Section 408A(c)(6)(B), qualified rollover contributions do not count toward the annual maximum contribution limit applicable to Roth IRAs."

401(k) / 403(b)

Employer-sponsored; private enterprise {401(k)} or govt/non-profit/education {403(b)}

Financed with pre-tax (‘Traditional 401(k)’) or post-tax (‘Roth 401(k)’, where available) money

Annual contributions limits ~$17,000 + catch-up provisions

Qualified withdrawals start at age 59.5, financial hardship, death, disability, plan termination

Early withdraws subject to a 10% penalty tax

401(k), 403(b), and 457(b/f) Accounts[edit]

All three of these plans are employee-sponsored tax-advantaged retirement plans; while they are typically funded with pre-tax money deducted from the paycheck, some institutions offer ‘Roth’ versions of each plan which are instead funded with post-tax money that is not taxed on withdrawal (see the section above on ‘Traditional vs Roth IRA’). These plans differ primarily in their eligibility requirements: 401(k) plans are available for employees of most businesses; 403(b) plans are available for employees of tax-exempt organizations established under IRS section 501(c)(3), including school teachers and administrators, doctors and nursers, ministers, and university professors, researchers, and staff; 457(b/f) plans are available for government and certain nonprofit employees. Many nonprofit governmental organizatons, such as public universities, offer both a 403(b) and 457(b) plans to their employees.

Wikipedia: 401(k) 403(b) 457(b/f)

Because they are funded with pre-tax money, contributions are not subject to income tax. Account assets grow tax-free, and are not subject to capital gains taxes while they remain within the account. Qualified withdrawals are subject to income tax and can be made when the account holder reaches a specified age; early withdrawals are subject to income tax and an additional excise tax of 10%. 401(k) plans typically include employer matching - the company will match a certain percentage of your account contributions up to a specified maximum - though 403(b) and 457 plans typically do not. Government 457(b) accounts have the added benefit of allowing withdrawal at early retirement or employment severance before the specified retirement age. The employer may compensate by setting the retirement age as high as 70.5 for employees who stay with the company for their entire career; this is commonly done by public universities.

Contributions are used to purchase mutual funds as in an IRA, though annuities are sometimes available.

All three plans have the same base annual contribution limits, called the ‘elective deferral limit’, and contributions can never exceed 100% of compensation. If you have a 403(b) and a governmental 457(b), you may contribute to both accounts up to their respective elective deferral limits; contributions to 403(b) and non-governmental 457(b) plans are summed and considered jointly against the elective deferral limit. Plans with employer matching have an ‘annual addition limits’ on plan contributions including employer matching.

Under some conditions, contribution limits are further increased. Plan participants 50 or older may make a ‘50+ catch-up contribution’. Participants who have been with the same employer more than a specified years and have contributed less than a specified average amount in previous years, and 457 particpants within three years of retirement age, are eligible to make an additional catch-up contribution.

A 403(b) participant in 2012 could contribute: Annual elective deferral limit: $17,000 Age 50+ catch-up contribution limit: $5,500 And for those with at least 15 years of service at the same organization: ‘15-year rule’ catch-up contribution limit: $5000 * (years of service) - (total previous contributions) with an annual limit of $3,000 and a lifetime limit of $15,000 under this provision

A 403(b) participant over 50 who had never contributed to their 403(b) could contribute as much as $25,500 per year; if this employee also participated in a governmental 457(b) and was within 3 years of retirement age, they could contribute over $50k per year. As demonstrated, these limits are extremely generous.

Employer Matching[edit]

Employers offering a 401(k), 403(b), or 457(b) plan may also offer some degree of ‘matching’. An employer offering matching will match a certain percentage of your contributions to your retirement plan, up to a stated maximum, with their own contribution to your plan.

If your employer offers matching, make sure to contribute enough to maximize their matching amount. This is free money in the purest sense! Take full advantage!

Scenario Two: your employer offers a 401(k), 403(b), or 457(b) with matching.

Contribute enough to the employer-sponsored account to maximize your employer’s matching contribution amount before contributing to an IRA or anything else. What securities should you buy with this money? Managed mutual funds have higher expense ratios and very often fail to beat unmanaged funds, so stick to unmanaged index mutual funds. Vanguard has many highly-rated index mutual funds with extremely low expense ratios; VTSMX and VGTSX are good domestic and international total market choices, respectively.


Limitations aside, a 401(k) is still a great destination for your money once you've maxed out your IRA for the year. If your company offers matching, contribute enough to the 401(k) to maximize your match before contributing to an IRA—it's free money!

No Employer-Sponsored Plan?[edit]