The 401(k) Versus a 457 Plan and What Does Roth Mean Anyway

We recently received a question from one of our podcast listeners about the difference between a couple government sponsored retirement plans and what the effects of a Roth retirement account would be.  Just a warning I’m going to be throwing around a lot of numbers in this post but I’ll try and keep it organized.

First we have the 457 plan.  This retirement account is very similar to our old friend the 401(k) with a few exceptions.  Only government employees and employees of tax-exempt organization can participate in a 457 plan.  Examples would be educational organizations, charitable organizations, hospitals, labor unions and trade associations.  So if you don’t work for the government or a tax-exempt organization you can skip ahead to the next section.   457 plans for government employees differ slightly from those offered to tax-exempt organization but here is what I found as the one advantage of a 547 Plan: You are not penalized for withdrawing money before age 59 1/2 like you are with a 401(k).  As far as the disadvantages: You cannot roll 457 plan money into any other type of tax deferred vehicle, unless it is another 457 plan.  In addition the money contributed to a 457 plan is the property of the employer not the employee (huge red flag for me).

Onto the 401(k).  A 401(k) plan works just like a 457 plan with the exception of allowing early withdrawals without penalty.  Making an early withdrawal (before age 59 1/2) from your 401(k) will result in a 10% penalty in addition to the income tax owed.  Both the 401(k) and the 457 plan allow for an employer match, and contribution limits are the same in both plans ($17,000 in 2012).

Now without shaking things up too much lets define what happens when we add the word Roth to a retirement account (this could be a roth IRA, roth 401(k) or roth 403(b)).  First a quick history lesson on the word Roth: Delaware Senator William Roth sponsored the tax payer relief act of 1997 which introduced the Roth IRA.  The diference between a traditional IRA/401(K)/403(b) and a Roth account is quite simple – the contributions to Roth accounts are made with after tax dollars.  Meaning the contributor received the money, paid the necessary income tax and then placed it into the retirement account.  With a traditional account the contributions are pre-tax, meaning the income tax is postponed until the money is withdrawn during retirement – at which point income tax will be paid on the received funds at the current income tax rate.

There seems to be endless debate as to which scenario puts the contributor in a more lucrative situation come retirement but I can help cut through all that mess with one simple question.  If you had to predict where tax rates would be in 10, 15 or 20 years from now do you think they would be higher, lower or the same?  If you think they will be higher you need a Roth-type account, or one that allows you to pay taxes now.  If you think taxes are going to be lower you’d be better off postponing your tax bill for a future date.

So you see, it really all comes down to taxes and how you think they will shift between now and retirement.  Before you do anything you should probably check out this post on tax deferral , I think it will help .



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Nick D.

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