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Help! I don't know what retirement plan you're talking about!

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(Read caption) Retiree Joseph Visintainer plops down on the floor of the coffee shop of his local senior center to greet a visiting dachshund dog in Seattle. What's the difference between a 401K and a Roth IRA?

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Connie writes in:

Roth, IRA, 401(k), 403(b), FERS, TSP – what on earth does it all mean? I know they all have to do with retirement savings, but it’s all just a word salad to me.

This is going to be something of a “dictionary” post where I spell out, as simply as I can, what these terms mean and what it means for you. I’m not going to get into every single detail of each term, but instead I want to give you enough information that you can sensibly navigate other articles you might read about retirement planning.

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A 401(k) is a retirement plan, meaning it’s a special way for you to put aside money for when you’re of retirement age. What makes a 401(k) better than a normal retirement account? For one, you can put aside money directly from your pay before taxes are taken out of it. This reduces the income tax you have to pay right now.

For most people, it means that you sign up to have a certain amount of money withdrawn from your paycheck each pay period. This money will come out before taxes, as mentioned above. This means your paycheck will be a bit smaller than it otherwise would, but it won’t go down quite as much as the amount you withdraw (because your taxes will be smaller, too). So, if you sign up to have 10% of your check taken out, your gross income might go from $2,000 to $1,800, but your take-home might only drop from $1,700 to $1,530.

When you’re retired and go to take money from a 401(k) account, that’s when you’ll pay income tax on your withdrawals. In a way, you’ll be able to think of it as a normal paycheck coming out of your 401(k) account, as it’ll have taxes taken out of it.

Sometimes, employers will match what you have withdrawn from your check. If this is available to you, get every dime you can. This is free money. Yes, you don’t have access to it right now, but there’s no easier way to cause your retirement savings to skyrocket than to get every dime of matching you can.

Typically, a 401(k) plan offers a lot of different options for how to invest your money. This can seem overwhelming. Thankfully, there’s a pretty easy solution that works for most people. Just ask your investment advisor for a “target retirement” fund and put all of your money into that fund. Usually, there are several different funds of this type, each of which “target” a specific retirement year. So, let’s say you’re 25 and you want to retire when you’re 64. That’s 39 years from now. Since I’m writing this in 2011, that puts your retirement date at 2050. Thus, you’d want to put your money into a “target retirement 2050″ fund. These funds take care of things like rebalancing for you so you don’t have to worry about it.

A 403(b) is almost identical to a 401(k). Why the different name? Generally, 403(b) plans are offered at non-profit organizations and institutions of public education, whereas 401(k) plans are offered from businesses. A 457 plan is also similar, except it’s typically offered by governments.

An IRA is a retirement account that you can set up on your own, usually with an investment house like Vanguard. You have to make your own contributions to this plan, which is usually done via an automatic deduction from your checking account.

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Contributions to an IRA are tax-deductible, which means that when you do your taxes, you can subtract the amount you contribute to your IRA from the total amount of income you’ll be paying income taxes on. For many people, this means a larger rebate check from the IRS.

As with a 401(k), when you make withdrawals from an IRA at retirement age, you have to pay taxes on those withdrawals as though they were normal income.

An IRA involves a lot more effort than a 401(k) for most people. You have to independently sign up for an IRA with an investment house. Once signed up, you’re going to have many more investment options than you would have with a 401(k), which is both good (options are good) and bad (lots of options can be overwhelming). As before, I typically encourage people to use a “target retirement” fund for all of their retirement savings if they’re unsure, which you can read about above in the 401(k) section.

OK, so what does Roth mean? A Roth IRA or a Roth 401(k) work similarly to the plans described above, except that instead of using pre-tax money, you’re using post-tax money for contributions.

How does that work? Your contributions come out of your take-home money in the case of a Roth 401(k), and your contributions aren’t tax deductible in the case of a Roth IRA.

Well, what do you get in exchange for that? All of the money you withdraw from these accounts at retirement is tax free. You won’t pay a dime of tax on any of it.

Naturally, this causes people to start asking questions like “is it better to pay taxes now or pay taxes at retirement time?” This is a debate that’s gone on for years and, frankly, there is no clear answer to it. My usual suggestion to people is to diversify. If you can, put some money into a Roth IRA or a Roth 401(k) and put some money into a regular 401(k) or a regular IRA.

A final note: what about FERS? FERS is essentially a federal pension plan available to federal employees. Many states offer a similar program with similar benefits to their employees. Typically, these plans offer a retirement pension based on years of service and salary and, typically, you don’t have to make any decisions after the initial sign-up.

Hopefully, this article helps you with the basics of various retirement plan options and makes it possible to navigate more in-depth articles about setting up things to cover your retirement.


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