401(k) Plans
Many employers set up a retirement plan that allows an employee to make an election between receiving current compensation or having part of the compensation go to a qualified retirement plan, such as a profit-sharing or a stock bonus plan. This type of plan is generally called a 401(k) plan (referring to the tax code section that created this type of plan), a cash or deferred arrangement (CODA), or a salary reduction plan.
If your employer offers its employees a 401(k) plan, consider yourself lucky. Your employer has the difficult part of setting up the plan, administering it and paying any costs related to the plan, which can be quite high. All you have to do, however, is make sure you reap the rewards of having a 401(k) plan.
As an employee, there really is no downside to contributing to a 401(k) plan. As an initial benefit, contributions to a 401(k) are made on a pre-tax basis so the employee sees an immediate tax savings. In addition, the money in your 401(k) will grow on a tax-deferred basis, making it even easier to save for retirement. This allows you to build your retirement nest egg quicker than if you saved on an after-tax basis.
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Example
Tommy Turtle, a slow and steady investor, makes $50,000 a year and invests 10 percent of his salary in his employer's 401(k) plan. Tommy's combined federal and state tax rate is about 40 percent, and he is 20 years from retirement. His $5,000 investment ($50,000 x .10) in the 401(k) reduces his taxable income for the year to $45,000 and he defers having to pay $2,000 of tax ($5,000 x .4) for the year. As a result, after taxes, he is left with $27,000 of disposable income for the year ($45,000 x .6).
Looking ahead and assuming similar investments earning a 6 percent annual rate of return, Tommy will have saved $100,000 in principal and made about $93,500 in tax-free interest income over the course of 20 years. Upon retirement, he will begin to be taxed on distributions made from his 401(k) plan.
Henry Hare is Tommy's co-worker and earns the same amount of money as Tommy. Henry is an overly confident investor and, unlike Tommy, decides not to invest in the 401(k) plan. Instead, he foolishly decides to just put $5,000 each year from his paycheck into a regular savings account earning 6 percent annually.
The $5,000 would have to come out of Henry's paycheck after taxes, leaving him only $25,000 of disposable income for the year [($50,000 x .6) - $5,000]. At the same time, the interest income on his savings is also taxed. As a result, Henry may save $100,000 in principal just like Tommy, but Henry's after-tax interest income comes out to less than half of the amount Tommy earns (about $46,600 to be more exact). The money Henry paid in taxes could have been earning interest for his retirement. Moreover, during the course of 20 years, Henry has $40,000 less in disposable income to spend compared to Tommy because he paid $2,000 more in taxes on his employment compensation each year. |
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Another benefit of participating in a 401(k) plan is that employers frequently match employee contributions or otherwise make additional contributions to the plan. Employers, of course, don't do this out of the goodness of their hearts (assuming they have them). A 401(k) plan, with matching employer contributions, is an important part of an overall compensation package that an employer uses to attract and retain qualified employees. Employers also provide additional contributions to the plan to encourage lower-paid employees to participate in the plan. Such participation is extremely important to the employer because the plan cannot discriminate in favor of highly compensated employees if it is to retain its status as a tax-favored qualified plan.
The following are some more things you should know about 401(k) plans:
- How a 401(k) Works: Although participating in a 401(k) is easy to do, you should still learn how such plans operate, and we help you do so.
- Changing Jobs and 401(k) Rollovers: Find out how your 401(k) is affected if you switch jobs. Also learn how to prevent your savings from being taxed prematurely by making a 401(k) rollover.
- 401(k) Distributions: Some day, you will be taking out money from your 401(k) and actually spending it. Discover when it is permissible to take a distribution and what the consequences are when you take an impermissible distribution.
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