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.