STORY BY C. RYAN SICK
mployer-sponsored qualified retirement plans such as 401(k)s are some of the most powerful retirement savings tools available. If your employer offers such a plan and you’re not participating, you should be. Once you’re participating in a plan, try to take full advantage of it.
Understand your employer-sponsored plan
Before you can take advantage of your employer’s plan, you need to understand how these plans work. Read everything you can about the plan and talk to your employer’s benefits officer. You can also talk to a financial planner, tax adviser and other professionals. Recognize the key features that many employer-
sponsored plans share:
- Your employer automatically deducts your contributions from your paycheck. You may never even miss the money — out of sight, out of mind.
- You decide what portion of your salary to contribute, up to the legal limit. And you can usually change your contribution amount on certain dates during the year or as needed.
- With 401(k), 403(b), 457(b), SARSEPs and SIMPLE plans, you contribute to the plan on a pre-tax basis. Your contributions come off the top of your salary before your employer withholds income taxes.
- Your 401(k), 403(b) or 457(b) plan may let you make after-tax Roth contributions — there’s no up-front tax benefit, but qualified distributions are entirely tax-free.
- Your employer may match all or part of your contribution up to a certain level. You typically become vested in these employer dollars through years of service with the company.
- Your funds grow tax-deferred in the plan. You don’t pay taxes on investment earnings until you withdraw your money from the plan.
- You’ll pay income taxes (and possibly an early withdrawal penalty) if you withdraw your money from the plan.
- You may be able to borrow a portion of your vested balance (up to $50,000) at a reasonable interest rate.
- Your creditors cannot reach your plan funds to satisfy your debts.
Contribute as much as possible
The more you can save for retirement, the better your chances of retiring comfortably. If you can, max out your contribution up to the legal limit (or plan limits, if lower). If you need to free up money to do that, try to cut certain expenses.
Why put your retirement dollars in your employer’s plan instead of somewhere else? One reason is that your pre-tax contributions to your employer’s plan lower your taxable income for the year. This means that you save money in taxes when you contribute to the plan — a big advantage if you’re in a high
tax bracket. For example, if you earn $100,000 a year and contribute $10,000 to a 401(k) plan, you’ll pay income taxes on $90,000 instead of $100,000. (Roth contributions don’t lower your current taxable income, but qualified distributions of your contributions and earnings — that is, distributions made after you satisfy a five-year holding period and reach age 59 1/2, become disabled or die — are tax-free.)
Another reason is the power of tax-deferred growth. Your investment earnings compound year after year and aren’t taxable as long as they remain in the plan. Over the long term, this gives you the opportunity to build an impressive sum in your employer’s plan. You should end up with a much larger balance than somebody who invests the same amount in taxable investments at the same rate of return.
For example, say you participate in your employer’s tax-deferred plan (Account A). You also have a taxable investment account (Account B). Each account earns 6 percent per year. You’re in the 24 percent tax bracket and contribute $5,000 to each account at the end of every year. After 40 years, the money placed in a taxable account would be worth $567,680. During the same period, the tax-deferred account would grow to $820,238. Even after taxes have been deducted from the tax-deferred account, the investor would still receive $623,381. (Note: This example is for illustrative purposes only and does not represent a specific investment.)
Capture the full employer match
If you can’t max out your 401(k) or other plan, you should at least try to contribute up to the limit that your employer will match. Employer contributions are basically free money once you’re vested in them (check with your employer to find out when vesting happens). By capturing the full benefit of your employer’s match, you’ll be surprised how much faster your balance grows. If you don’t take advantage of your employer’s generosity, you could be passing up a significant return on your money.
For example, you earn $30,000 a year and work for an employer that has a matching 401(k) plan. The match is 50 cents on the dollar up to 6 percent
of your salary. Each year, you contribute 6 percent of your salary ($1,800) to the plan and receive a matching contribution of $900 from your employer.
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