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Roth 401(k), 457/Deferred Compensation, and SEP Plans

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Roth 401(k)

A Roth 401(k) offers the same benefits as a traditional 401(k), but it is funded with after-tax money rather than pre-tax money. This means that your money will grow tax-free and can be withdrawn tax-free as well. Besides the tax advantages, Roth 401(k) plans do not have income restrictions. Contributions are still limited, however.  If you have a traditional and a Roth 401(k), the yearly contribution limits would apply across both accounts, not for each individually. Additionally, funds cannot be withdrawn without penalty from these accounts before age 59 ½ unless special conditions such as financial hardship are met.  These limits are expected to change every year with inflation, so check with this IRS page (http://www.irs.gov/Retirement-Plans/COLA-Increases-for-Dollar-Limitations-on-Benefits-and-Contributions) for the current limits.

Whether a Roth 401(k) is right for you depends on your age and current tax bracket. Roth accounts are generally better for people in their 20s and 30s. This group is usually in a lower tax bracket than older workers, and they have a longer time to allow money to grow. Younger workers are likely to be in a higher tax bracket in retirement, so they could potential save money by paying taxes up-front. Also, if tax rates go up, which is likely, you may do better with a Roth 401(k).

Besides their different tax treatment, Roth 401(K) accounts also handle employer contributions differently as well. In a traditional 401(k) some employers will match employee contributions. This is still an option in a Roth 401(k). The employer match will still be calculated from pre-tax money, but the matching funds must are placed in a separate account. Accordingly, the matching funds will be taxed as normal income upon withdrawal even while the employees own contributions will be tax free.

Although a Roth 401(k) can be a good investment vehicle, it is a newer investment vehicle and not all employers offer it yet. Also, not all human resource representatives will be able to highlight the benefits of choosing a Roth 401(K) vs. a Traditional 401(K) for the same reason. Check with your company's human resources department and get advice from a qualified professional before you make these kinds of important investment decisions.

457/Deferred Compensation

Another investment vehicle that offers special tax treatment is the 457 or deferred compensation plan. The idea behind 457s is that taxes will be deferred until you are in retirement when (hopefully) you will also be in a lower tax bracket. 457 plans are generally offered by state and local governments and other organizations, such as charities, religious organizations, private hospitals, trade unions, fraternal orders, etc., that are exempt from federal income tax.

457 contributions are pre-tax just like 401(k) contributions but are limited to certain percentages of your income. These limits are expected to change every year with inflation, so check with this IRS page (http://www.irs.gov/Retirement-Plans/COLA-Increases-for-Dollar-Limitations-on-Benefits-and-Contributions) for the current limits. The difference between a 457 and a 401(k) is that contributions to the former are considered pay that you have voluntarily decided not to receive until a later date. Doing so reduces the amount of federal and state tax that you are subject to now. However, your net salary (the amount you take home after taxes are paid) is reduced by only a part of the total amount you defer. For example, if you defer $100, your net salary may be reduced by only $85.

As with 401(k) investment options, you will generally be presented with a rather limited number of mutual fund choices for how you may invest your 457 monies. Withdrawals are taxed as income and are subject to penalties if taken before you are 59 ½. Financial hardship exceptions similar to other qualified plans also apply for 457 programs.

Simplified Employee Pension (SEP)

A Simplified Employee Pension (SEP) is a type of retirement account available to small businesses with up to 100 employees. What distinguishes a SEP from other retirement plans is that the employer is responsible for all making contributions to the SEP accounts and the same percentage of compensation must be contributed for all employees. Contributions are tax-deductible for the employer, but the employee still benefits from tax-deferred growth. Contribution amounts are limited.  These limits are expected to change every year with inflation, so check with this IRS page (http://www.irs.gov/Retirement-Plans/COLA-Increases-for-Dollar-Limitations-on-Benefits-and-Contributions) for the current limits. Withdrawal rules are similar to other qualified plans: Withdrawals taken before the participant is 59 ½ are subject to a 10% penalty and tax consequences. Financial hardship withdrawals are excepted. Employees can invest in mutual funds and annuities as with a Traditional IRA.