Understanding employer-sponsored plans

Before taking advantage of an employer's plan, it's important for employees to understand how these plans work. They should read everything possible about the plan and talk to the employer's benefits officer. Other options are to talk to a financial planner, a tax advisor, and other professionals. Recognize the key features that many employer-sponsored plans share:

• An employer automatically deducts contributions from an employee's paycheck. Employees may never even miss the money--out of sight, out of mind.
• An employee decides what portion of their salary to contribute, up to the legal limit. And they can usually change their contribution amount on certain dates during the year.
• With 401(k), 403(b), 457(b), SARSEPs, and SIMPLE plans, an employee contributes to the plan on a pretax basis. Contributions come off the top of an employee's salary before their employer withholds income taxes.
• A 401(k), 403(b), or 457(b) plan may let an employee make after-tax Roth contributions--there's no up-front tax benefit but qualified distributions are entirely tax free.
• An employer may match all or part of their contributions up to a certain level. An employee typically becomes vested in these employer dollars through years of service with the company.
• An employee's funds grow tax deferred in the plan. They don't pay taxes on investment earnings until they withdraw their money from the plan.
• An employee will pay income taxes and possibly an early withdrawal penalty if they withdraw their money from the plan.
• An employee may be able to borrow a portion of their vested balance (up to $50,000) at a reasonable interest rate.
• Creditors generally cannot reach plan funds to satisfy an employee's debts.

Employees can consider contributing as much as possible

The more one saves for retirement, the better their chances of retiring comfortably. If possible, max out contributions up to the legal limit. If money needs to be freed up to do that, employees can try to cut certain expenses.

Why put retirement dollars in an employer's plan instead of somewhere else? One reason is that pretax contributions to an employer's plan lower taxable income for the year. This means money is saved in taxes when contributing to the plan--a big advantage if one is in a high tax bracket. For example, if earning $100,000 a year and contributing $10,000 to a 401(k) plan, expect to pay income taxes on $90,000 instead of $100,000. (Roth contributions don't lower current taxable income but qualified distributions of contributions and earnings--that is, distributions made after satisfying a five-year holding period and reaching age 59½, become disabled, or die--are tax free.)

Another reason is the power of tax-deferred growth. Investment earnings compound year after year and aren't taxable as long as they remain in the plan. Over the long term, this offers the opportunity to build an impressive sum in an employer's plan. It should provide a much larger balance than somebody who invests the same amount in taxable investments at the same rate of return.

For example, an employee is participating in an employer's tax-deferred plan (Account A). They also have a taxable investment account (Account B). Each account earns a hypothetical 8 percent per year. The employee is in the 28 percent tax bracket and contributes $10,000 to each account at the end of every year. They pay the yearly income taxes on Account B's earnings using funds from that same account. At the end of 30 years, Account A is worth $1,132,832, while Account B is worth only $757,970. That's a difference of over $370,000. (Note: This example is for illustrative purposes only and does not represent a specific investment.)

Capture the full employer match

If an employee can't max out their 401(k) or other plan, they should at least try to contribute up to the limit their employer will match. Employer contributions are valuable for employees once they're vested in them (employees should check with their employer to find out when vesting happens). By capturing the full benefit of an employer's match, they'll be surprised how much faster their balance grows. If they don't take advantage of their employer's generosity, they could be passing up a significant opportunity.

For example, an employee earns $30,000 a year and works for an employer that has a matching 401(k) plan. The match is 50 cents on the dollar up to 6 percent of their salary. Each year, they contribute 6 percent of their salary ($1,800) to the plan and receive a matching contribution of $900 from their employer.

Employees should evaluate investment choices carefully

Most employer-sponsored plans offer a selection of investment options to choose from. Employees should make choices carefully. The right investment mix for an employer's plan could be one of the keys to a comfortable retirement. That's because over the long term, varying rates of return can make a big difference in the size of an account's balance.

Employees can research the investments available. How have they performed over the long term? Have they held their own during down markets? How much risk will they expose an investor to? Which ones are best suited for long-term goals like retirement? An investor may also want to get advice from a financial professional (either their own, or one provided through their plan). He or she can help pick the right investments based on personal goals, attitude toward risk, how long until retirement, and other factors. A financial professional can also help coordinate a plan's investments with an employee's overall investment portfolio.

Finally, there may be options to change investment allocations or move money between the plan's investments on specific dates during the year (e.g., at the start of every month or every quarter).

Employees should know the options when leaving an employer

When leaving a job, the vested balance in a former employer's retirement plan is for the employee to keep. They have several options at that point, including:

• Taking a lump-sum distribution. This is often a bad idea, because they'll pay income taxes and possibly a penalty on the amount withdrawn. Plus, they're giving up continued tax-deferred growth.
• Leaving funds in the old plan, growing tax deferred (the old plan may not permit this if the balance is less than $5,000, or if an employee has reached the plan's normal retirement age--typically age 65). This may be a good idea if they're happy with the plan's investments or need time to decide what to do with their money.
• Rolling funds over to an IRA or a new employer's plan if the plan accepts rollovers. Depending on each employee's particular set of needs, goals and circumstances, this can be a smart move because there will be no income taxes or penalties if the rollover is done properly (the old plan will withhold 20 percent for income taxes if the funds are received before rolling them over). Plus, funds will keep growing tax deferred in the IRA or new plan.