Installment Three in Our Series on How to Effectively Manage Your 401(k) Plan
A 401(k) plan is an employee benefit plan that allows an employee to save for retirement and offers the employee several advantages over saving outside of the 401(k). 401(k) plans are named for the section of the Internal Revenue Tax Code that authorized them. These plans allow employees to defer a portion of their pay by contributing it to the plan. Contributions to the plan are not subject to federal taxes nor are the earnings until the funds are removed at retirement when they are taxed as regular income. State tax laws regarding 401(k) contributions vary. Some states (Pennsylvania being one) tax contributions to 401(k) plans but do not tax withdrawals (including earnings). Others treat them the same way that the federal tax code does. It is important to check with your tax advisor about how your state taxes 401(k) contributions, earnings and withdrawals.
Contributions to a 401(k) plan can only be made by payroll deduction. Currently (2013) an employee may defer up to $17,500 per year*. Individuals age 50 and older can defer an additional $5,500, referred to as a “catch-up” contribution. These limits are indexed for inflation and will rise if inflation increases.
Example(s): Assume Alice is employed by a department store. She earns $30,000 annually. Alice defers $5,000 of her earnings to the store's 401(k) plan. As a result, Alice's taxable income is now $25,000. She isn't taxed on the deferred money ($5,000) until she receives a distribution or makes a withdrawal.
The biggest advantage gained in contributing to your 401(k) lies in the tax deferral on contributions and earnings. Tax deferral can be beneficial because:
· The money you would have spent on taxes remains invested
· You may be in a lower tax bracket when you make withdrawals from your accounts (for example, when you're retired), and
· You can accumulate more dollars in your accounts due to compounding
· No capital gains taxes on sales of assets in the plan
Compounding means that your earnings become part of your underlying investment, and they in turn earn interest. In the early years of an investment, the benefit of compounding may not be that significant. But as the years go by, the long-term boost to your total return can be dramatic.
Example(s): Let's assume two people have $5,000 to invest every year for a period of 30 years. One person invests in a tax-deferred account like a 401(k) that earns 6% per year, and the other person invests in a taxable account that also earns 6% each year. Assuming a tax rate of 28%, in 30 years the tax-deferred account will be worth $395,291, while the taxable account will be worth $295,896. That's a difference of $99,395 or 33% more!
Other Advantages to investing in your 401(k) Plan
Funds held in a 401(k) plan are fully shielded from an employee's creditors under federal law in the event of the employee's bankruptcy. If your plan is covered by the Employee Retirement Income Security Act of 1974 (ERISA), plan assets are also fully protected under federal law from the claims of your company’s creditors, even outside of bankruptcy. State law may provide additional protection. Money in a 401(k) plan is considered by law to belong to the employees, so even if your employer goes bust your 401(k) will not. It is important that you monitor your plan to make sure that your contributions are being deposited to the plan in a timely manner. Most problems with fraud involving 401(k) plans involve the employer not remitting employee contributions to the plan vendor. If more than a month passes and your contributions have not appeared in your account, see your Human Resources department and ask why.
Convenience of pay-roll deduction dollar cost averaging
Most people tend to find saving easier when the money comes out of their paycheck before they have access to it. In addition, when we contribute the same amount at regular periods of time to funds investing in financial markets that fluctuate we are able to buy more shares when prices are low and buy less shares when prices are high, this is precisely what investors should do. The payroll deduction nature of 401(k) contributions provides a discipline to your retirement investing.
Difficulty in accessing the funds for purposes other than retirement
As we will see in later, it is more difficult to access funds in your 401(k) for purposes other than retirement than if the funds were invested in a taxable account. I view this as a strong advantage because, and I cannot stress this strongly enough, to successfully fund an adequate retirement, you must save at least 10% of your gross earnings every year and you cannot touch the money for any other reason.
· Depending on how your plan is structured you may enjoy these other advantages offed by 401(k) plans:
· Access to low cost, no load index funds
· Access to inexpensive professional investment advice
· Record keeping convenience
· Employer match
· See your Human Resources Department to find out what your plan offers
What your 401(k) is not
401(k) plans were never intended to be the sole source of retirement income for employees. Rather they were intended to be combined with social security which is a guaranteed retirement safety net which was to provide a subsistence level retirement benefit. They also are not pension plans that provide a guaranteed benefit without employee contributions or control of investments, nor any guaranteed benefit at all. The benefit you receive at retirement from your 401(k) is wholly dependent on how much you contribute and how successful you are at investing it. *Certain employees may be limited as to how much they can contribute to a 401(k) if they are considered highly paid or have significant ownership in the employer sponsoring the plan. These rules were put in place to prevent 401(k) plans from primarily benefiting the owners of a company or its highest paid employees. The rules covering these individuals are extremely complicated and are beyond the scope of this discussion. If you believe you might be impacted by these rules, see your Human Resources department for a determination of how much you can contribute.