Stony Brook Securities welcomes Bobby, who is a police officer and has been on the force for 6 years now, to our blog. Bobby did not know what a 401a account was but as he works in the public section it is far more of an option for him than for someone in the private sector. Bobby wanted to write a post about this as he thought it would help others.
A retirement account is a great way to prepare for your future, and the sooner that you start contributing to one, the better your prospects for sustaining your lifestyle in your golden years of retirement. There are many different types of retirement accounts to choose from. There are employee-sponsored plans and individual plans. Both of these categories include plans that meet that criteria of Section 401(a) of the Internal Revenue Service. A plan has to meet the criteria under 401(a) in order to be available for tax-free or tax-deferred status.
Two types of common employee-sponsored retirement plans are the 401k and the 401a. A 401k is technically a type of 401a. It is set up according to the stipulations in tax code 401(a), but 401k’s and 401a’s are generally referred to as two separate entities. Here we will go over the basics of these two plans, and discuss the standards and benefits of the 401a versus 401k.
401k vs 401a…What Do They Have in Common?
Let’s start by talking about what the two plans have in common. They are both employer-sponsored plans. Both may include employee and employer contributions. Both often have the option to contribute employee dollars pre-tax. Both ensure that the funds are invested in stocks, bonds, or various funds, in order to take advantage of growth and compound interest. Finally, both come with hefty tax penalties if the money is withdrawn early.
401k vs 401a…How Are They Different?
Now, there are several ways in which the plans differ. One difference regarding the 401a vs 401k is in who the plans are available too. A 401k is a type of investment plan that is usually offered to employees of corporations and private companies. A 401a is offered to employees of the government, educational institutions, and nonprofit organizations. A 401a is sometimes given to these types of employees, in addition to a 401k, whereas employees of corporations are usually only offered a 401k.
A 401k is offered to every employee of a company, and the plan’s options are the same, regardless of employee longevity, position, or status. All employees have the same options regarding their contributions and are given the same employer matching benefits. A 401a, on the other hand, is often custom made for specific employees, and may not be made available to everyone that works for an organization. Sometimes a 401a is given as part of an incentives package to reward longevity or given in accordance with promotions, or certain positions within a company.
Another major difference, regarding the 401a vs 401k, is in the level of control that employees have. A 401k gives an employee much more control than a 401a. A 401k is optional and employees can choose whether or not they wish to participate. If employees do choose to participate in their company’s 401k program, they get to decide how much of their earnings they wish to contribute. In the case of a 401a, participation is compulsory, and often employees can not opt out. There is also a difference in levels of control when it comes to employee contributions. The 401k is the clear winner, in the category of employee decision-making. With a 401k, an employee can decide to contribute as much or as little as they choose. There are often amounts that employees cap out at, and once they have passed this cap, they can no longer make contributions to their 401k. Employees usually have several contribution options and can decide whether to contribute three, five, or even ten percent of their pre-tax pay.
In the case of a 401a, the employer has control over the employee contribution amounts. They will often set a dollar amount or a percentage, and the employee must have this contribution amount deducted from their pay and added to their 401a. Some employers will give the employees a few different plans to choose from, and this gives the employee a degree more control over how much money must be contributed, but the 401k is still the option that allows for more employee control.
The 401a vs the 401k has a similar situation when it comes to investment decisions. With a 401k, employees have a large amount of control over how their dollars are being invested. How the plan is invested is important, because capital gains and compounding interest can make a huge difference in how a plan’s money performs and grows. With a 401a, just as with employee participation and employee contributions, it is the employer that makes the decisions, regarding how the money is invested.
That brings me to my next point. There are some key differences in a 401a vs a 401k, regarding how the money is invested. 401k portfolios are often very diverse. 401k funds are usually dispersed across several types of funds. These most often include mutual funds and index funds, but can also include individual stocks, as well as more low-risk options such as bonds and securities. Some people with 401k’s choose to make these investment decisions themselves, investing in blue-chip stocks or newer companies as they see fit. Some with 401k’s choose to have their money actively managed by a financial professional, or sometimes a fiduciary. If a fiduciary is an option, it would be wise to go this route, rather than using a financial professional that is not licensed as a fiduciary.
With a 401a, the investments tend to be much more low-risk and conservative. Funds are often invested in bonds, or other assets, that minimize the risk of loss. Unfortunately, higher risk is closely correlated with higher returns. By minimizing investment risk, the chances of greatly growing the principal balance are minimized as well.
401k vs 401a…What About IRA’s?
It’s because of this conservative investment strategy that 401a work best as supplemental retirement plans, used in addition with an employer-sponsored 401k, (if that is an option), or alongside an individual retirement plan. This could include a standard IRA, or a Roth IRA. With a Roth IRA, contributions are not taken pre-tax. The money is taxed now, instead of being taxed when it is withdrawn, at the time of retirement. A 401a is also beneficial to anyone who prefers low-risk investments, either because they don’t like to take risks with their money or because they don’t expect the market to do well.
When it comes to the 401a vs 401k, a 401a might also prove more beneficial to someone close to their retirement age. The closer that a person is to their target retirement date, the more it becomes necessary for risk to be minimized. The time to take risk with a portfolio is when a person is young. The reason for this is because it can sometimes take several decades to significantly grow a portfolio. If a person is at the very start of their career, and the market takes a turn for the worse and they lose half of their investment, they then have thirty or so years, to ride the ups and downs of the market and let compounding interest do its thing. If a person is retiring in five or ten years, then they just don’t have enough time to recoup from losses. It’s for this reason that the potential for losses needs to be minimized depending on how close a person is to retirement.
The last difference, in the 401a vs 401k, is in how the funds are vested. Vested refers to how much of a fund the employee owns. It is in this regard, that the 401a holds an advantage. Most 401a plans are fully-vested. This means that the employee holds full ownership of it. This doesn’t always happen right away, and sometimes a plan is on a set vesting schedule. Usually, when this happens, an employee is given a greater percentage of ownership each year (or sometimes every few years) and this schedule continues until the employee is fully vested.
It’s for this reason that a 401a is beneficial to the employer. The knowledge that they are still working towards a full-vested plan, encourages employees to stay with a company. It provides an incentive for longevity and minimizes turnover. Once an employee is fully-vested, they own their entire plan, including employer contributions. There is still a penalty if funds are withdrawn early, but employees that are fully-vested can move on to other jobs or change careers without fear of losing that company matching money. Conversely, 401k plans sometimes work the same way, but a lot of the time they do not fully-vest, and if an employee decides to leave, they can end up losing those employee-matching dollars.
401a vs 401k Wrap Up
When it comes to choosing which one is right for you, every individual situation will be different. Anyone who feels confident in their investing knowledge and skills, and can spend the time managing their portfolio, might prefer a 401k. A person who doesn’t want the burden of being strategical with their money might want to leave that responsibility to someone else. In that case, a 401a may be ideal.
A person who is looking for lower risk may favor a 401a, while a person looking to maximize their returns and build an adequately diversified portfolio might decide on a 401k.
Awesome job Bobby! Great post! I am sure this will help a lot of people. And again, thank you for everything you do each and every day.