The 401(k), 403(b) and 457 are all retirement savings plans that that also serve as tax shelters. This means that participation in these plans can help you save for your retirement and when properly executed, will help minimize your tax liability today and in the future. All three can take advantage of the power of compound interest so that you can make your money work for you. In this article, I’m going to explain in detail what these accounts are, contrast their differences and describe how to effectively employ them to maximize retirement savings and portfolio growth while minimizing taxes.

The 401(k) Retirement Savings Plan

Let us start with the 4 most common of the three, the 401(k). The 401(k) is an employer-sponsored savings plan commonly offered by private companies as an added benefit to their employees. Employees will contribute to their 401(k) via payroll deductions, which effectively reduces their taxable income thereby reducing their annual tax liability. You may be thinking that this is incredible and that you’ll contribute your entire paycheck! Well, there are limits to how much an employee can contribute each year. The IRS sets these limits and it tends to change every few years. In 2018 the maximum 401(k) contribution was $18,500. In 2019, it was raised to $19,000 to keep up with inflation. Additionally, how much you can contribute is also dependent on how much you can afford to save, as saving to a 401(k) is a long term commitment. You typically cannot touch 401(k) funds until you’re at least age 59 1/2 and have stopped working.

There are additional 401(k) benefits. In addition to the income tax savings, some employers will help you save for retirement by giving you FREE MONEY in the form of an employer match. This is also known as an employer contribution. The employer match is commonly a percentage of the employee’s contribution, sometimes 25% (or any percentage deemed by the employer), or sometimes 100% up to a certain amount. Therefore, the more the employee contributes, the more FREE MONEY they will receive in the form of an employer match. As a general rule, always contribute the amount necessary to maximize your employer’s 401(k) contribution. Hey, its FREE MONEY!

401(k) Considerations

The 401(1k) is a retirement savings account. The IRS does not want you to touch this money until you are of retirement age. And while all the money in the vested 401(k) account is your money, the IRS discourages you from touching it by imposing a 10% early withdrawal penalty on any amount you withdraw if you are still working and under the age of 59 1/2. Don’t forget that any amount withdrawn is ALWAYS subject to income tax, regardless of age. That means 10% penalty AND income taxes on any amount withdrawn before 59 1/2. One should carefully consider one’s lifestyle and spending habits before determining one’s 401(k) contribution amounts. Saving money only to be hit with a 10% penalty and income taxes is not a sound investment strategy.

So what do I do if I need the money???

Most 401(k) plans offer the ability to borrow against the account itself at a nominal interest rate. This is referred to as a 401(k) loan. There are limits on the maximum loan amounts set by law and special rules and requirements for repayment. Some employers may have minimal loan amounts too. Repayment is made through payroll deductions and the longest repayment term allowed is five (5) years. This all changes if you lose your job while you have an outstanding loan. You will, most likely, be required to pay back the loan within 60 to 90 days or risk having the loan categorized as an early withdrawal and face the penalties and taxes mentioned above. And while that’s not good, here’s some great news. Interestingly, you pay yourself the interest. The interest you pay on a 401(k) loan goes back into your own 401(k) account balance. With a 401(k) loan, you are technically borrowing money against yourself and paying yourself back, with interest. Unfortunately, that interest is considered income and you pay taxes on it. And, since it’s going back into your 401(k), you’ll pay taxes again when you withdraw it later, effectively making it double-taxed.