Question

Evaluate the following statement: 'A 401-k offers a guaranteed tax free income stream while a Roth IRA is subject to market risk and taxes on capital gains.'

Answer 1

For many people, saving for retirement means squirreling away as much as possible through employer-provided plans, the most popular being the 401(k).

The 401(k) — named for a section of the tax code — is a type of defined-contribution plan, where you make regular contributions into a retirement account that you own. You make all of the investment decisions, unless you hire a professional to help you out. This differs from a defined-benefit pension plan, which provides workers with a guaranteed paycheck (or lump sum) in retirement — and the onus is on the employer to finance it. Many companies have phased out pension plans in recent years given their high costs, which means that most people need to worry about financing their own retirement.

While retirement plans differ — and go by an alphanumeric soup of names — most medium-sized and large companies offer 401(k)’s. There are two similar varieties — 403(b) and 457 plans — with the former offered to certain employees of public schools, hospitals and certain tax-exempt organizations, while the latter is provided to governmental employees. If you work for a small business, you might be offered a different type of plan, but the inner workings and concept will most likely be similar to those of a 401(k).

Employer-sponsored plans are usually the place you want to start saving for retirement because many employers match a piece of your contribution — and that serves as a guaranteed return on your money. They also provide certain tax benefits. Traditional 401(k)’s and similar plans allow employees to make their contributions on money that has not yet been taxed. So you’re effectively reducing your taxable income by the amount you contribute.

The mechanics of a 401(k) plan are relatively simple: An employee must first decide the amount to contribute, typically measured as a percentage of salary. The contributions are automatically deducted from your paycheck, but they’re subtracted from your gross income (before you’ve paid any income tax). By deferring, say, 10 percent of your salary, you’re also reducing your taxable income by 10 percent. So if you earn $60,000 annually and make a 10 percent contribution, you will be taxed on only $54,000. Contributions are held in your account and are invested in any of the mutual funds on a menu selected by your employer. (If new employees do not sign up for the company plan, some employers will sign them up automatically.)

Most 401(k) plans provide matching contributions. So if you set aside 10 percent of your salary, your company should make a matching contribution each time you do. Most companies that provide matching contributions match up to 3 percent of pay, but they use different formulas to get there. For instance, some companies will match you dollar for dollar up to 3 percent of pay, but more companies tend to pay 50 cents for every dollar you contribute, up to 6 percent of your pay.

All of the money inside the account grows tax-deferred, but ordinary income taxes will be owed on all withdrawals. If you want to avoid paying any penalties, you must wait until you are 59 1/2 to start tapping your 401(k). Individuals who leave their employer during the year of their 55th birthday or later may also begin to withdraw funds penalty-free.Before then, you’ll pay a 10 percent penalty fee on top of ordinary income taxes.