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Focus on 401(k)s
By Kimberly Clouse
Under a 401(k) plan, an employee can elect to contribute pre-tax dollars to
a qualified tax-deferred retirement plan rather than receiving her
compensation in cash, which would be fully taxable. Annual contributions for
2001 were $10,500, 2002 is $11,000 and 2003 is expected to be $12,000. The
IRS revises the limit based on inflation. Employees benefit from 401(k)
plans because they reduce their tax bills in the year of contribution and
their savings grow tax-deferred until retirement. Companies favor these
plans because they are generally less costly than traditional pension plans,
and therefore employers frequently match employee contributions. More
specifically:
- Income tax reduction. 401(k) contributions are
made by employees with pre-tax dollars, meaning that income
tax will be due on the amount remaining after the contribution;
this amount will be smaller and thus your tax bill lower.
For instance, if you earn $30,000 annually, you would pay
Uncle Sam $8,400 (assuming you fall in the 28% tax bracket).
If you were to contribute 10% of your salary to a 401(k)
plan, your taxable income would decline by $3,000 to $27,000.
At the 28% rate, with a $3,000 contribution, your federal
tax bill would fall by $840 ($3,000 multiplied by 28%).
In short, monies that would otherwise have gone to the government
will be working for you in your retirement account, and
you will have reduced your tax bill in the process.
-
Deferred taxation. Not only are contributions
to 401(k) plans tax-deductible, subsequent earnings on those
monies compound free of tax until you withdraw the money
at retirement. Your retirement savings will accumulate faster
given this tax-deferral because instead of paying taxes
annually on any interest or dividends you might earn, those
amounts simply stay within your 401(k) account and continue
to work toward funding your retirement.
- Employer matching. Employers are using immediate
eligibility as well as more generous matching and vesting
provisions to make compensation packages more attractive
in a tight labor market and to encourage employee participation.
Some employers will allow employees to establish 401(k)
plans as soon as they join the company instead of having
to wait a year, which used to be the norm. Employers can
increase matching contributions and eliminate vesting periods,
meaning that you will immediately "own" monies that your
employer invested in your 401(k) plan. (Note: The IRS has
set limits on the total amount that may be contributed to
your 401(k) account from all sources combined, including
any employer matching, to the maximum of the lesser of $30,000
or 25% of your total compensation.) Be sure to read the
fine print when you review your benefit information--some
companies do not match contributions at all or may require
a minimum period of service, such as five years, before
any employer contributions vest. In today's labor market
in which "job hopping" is becoming more and more commonplace,
such provisions could leave an employee with too little
saved for retirement. 401(k) plan provisions and employer
contributions can have such a powerful impact on your overall
compensation package that in some cases accepting a lower-salary
job accompanied by a generous 401(k) plan could actually
be a better financial choice than opting for a hefty salary
with less attractive 401(k) provisions.
This column is designed to provide accurate and authoritative
information on the subject of personal finances. It is provided with the understanding
that the Author is not engaged in rendering legal, accounting, or other professional
services by publishing this column. As each individual situation is unique,
questions relevant to personal finances and specific to the individual should
be addressed to an appropriate professional to ensure that the situation has
been evaluated carefully and appropriately. The Author specifically disclaims
any liability, loss or risk which is incurred as a consequence, directly or
indirectly, of the use and application of any of the contents of this work.
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