By Judy Loy
Registered Investment Advisor, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc.
Given the drama that has started 2021, I decided to go for something solid and informative for this article. When I talk to clients, they use a 401k account as a general term assuming any retirement plan through work or when moved to an IRA is still a 401k. This is not the case and it is important to know the differences. Each retirement type differs in options, withdrawals and costs so it is important to know these when deciding on rollovers or transfers to an IRA or other plan.
A traditional IRA and a Roth IRA are retirement accounts setup by an individual, not an employer. Depending on adjusted gross income and other factors, an individual can contribute to these plans if they have earned income. Employer retirement plan accounts can be rolled into these individual retirement accounts but do not need to be. The decision to leave an employer plan for an IRA should be based on options in the plan, costs in either account, a need for assistance in investing and other factors.
Companies with fewer than 100 employees can offer a Simple IRA. This type of plan was created recently compared to other plans and was created as an alternative to a 401k for a small business. It is attractive to a smaller business as there is less administrative costs and testing than a 401k. The employer can choose a matching contribution of 3% or a non-elective contribution of 2%. All contributions to a Simple are pre-tax so there are no Roth options. The major differences to the employee is in contribution limits and distribution options. The Simple permits a smaller maximum employee contribution than the 401k plan. It also has a large penalty for pulling from the Simple within two years of the first contribution. If the employee leaves the company after a year of contributing, they need to leave the money in the plan for another year or face a large 25% penalty. These plans are excellent for a small employer that wishes to benefit their employees and themselves for retirement. We used this initially as our retirement plan at Nestlerode and switched to a 401k later.
A SEP IRA is also a plan for small business and many times is only used by one-person firms. The advantage to a SEP is the employer does not need to contribute annually and the decision is made at tax time when revenue is known for the year. The employer matches a certain percentage of the employee’s salary (the percentage must be the same for all employees). There are no employee contributions, and it works similarly to profit-sharing.
A 401k is an employer plan that is guided by the 401k document and investment options are decided by the fiduciary, usually the company’s representative. A 401k has the most bells and whistles of any retirement option and thus is the most costly for the employer to administer. A 401k may offer an employer match and permits the employee the largest contribution limits. At its best, a company 401k offers both employer matching and profit-sharing options. This means the company offers to put money in the plan for the employee if the employee puts money into the plan. An employees’ contributions are always 100% vested, which means the money that you commit from your paycheck remains yours regardless of how long you are at the company. The profit-sharing typically has a vesting schedule, which means you get more of that money up to 100% of your account the longer you stay at the company, thus incentivizing and benefitting from long-term employment.
The information above is generalized and you should always carefully read your benefits and make a personalized decision about what works for you. There are many details to look at when deciding on a retirement plan for your business or whether to leave money in a company’s retirement account. These choices depend on your needs and the plan’s options and costs. One thing I will suggest for everyone: If a company has a matching contribution, take advantage of it! That is an immediate tax-free return on your money that you won’t find elsewhere.