Salary-reduction plans (401(k), 403(b), and 457 plans) allow employees to deposit, through payroll deduction, part of their pre-tax salary into a retirement account on a tax-deferred basis. This means that the amount contributed to the retirement savings plan, as well as investment earnings, grow free from income taxes, sometimes for many decades (depending upon the age of the worker). The money placed into a plan account is not taxed until you start making withdrawals, typically in retirement.
The most familiar type of salary reduction plan is the 401(k), which is the salary reduction retirement plan for employees of private corporations. It is named for the section of the tax code that describes it. The 2009 limit on the maximum amount that can be contributed to a 401(k) is $16,500 ($22,000 for workers age 50 and over with an additional $5,500 catch-up contribution). Contributions are deducted directly from a worker’s paycheck (e.g., 5% of your annual salary divided by the number of paychecks received per year).
Some employers contribute an additional match, which is a percentage of workers’ contributions. Contribution policies can vary according to economic conditions and company profitability. A common employer matching formula is 50 cents for every dollar that a worker contributes up to 6% of pay. Many companies also allow their employees to borrow up to one-half of the funds in their 401(k) account for any reason. Interest paid by the employee on the money that is borrowed from a 401(k) is paid back into the employee's own account.
Below is some additional information and advice about 401(k) plans:
• By contributing part of your salary to a 401(k), your gross income for federal income taxes (state laws vary) is reduced by the amount that you set aside. As a result, you will see two different dollar amounts in the boxes on your W-2 form and will report the lower amount that subtracts the 401(k) contribution.
• Because you are contributing pre-tax dollars to a 401(k) (i.e., you pay no federal income tax on the amount of the contribution, as well as the earnings that are generated), the account grows much faster than savings options funded with after-tax dollar deposits (i.e., money that has already been taxed before investing).
• Once you decide what percentage of pay to contribute from each paycheck, you need to divide it among a 401(k) plan’s available investment options. The investments that you can select from are limited to those offered by the 401(k) plan administrator. Your 401(k) plan administrator should provide you with a prospectus about available investments. If a certain type of investment (e.g., stock index fund) is not available in the plan, workers can purchase it on their own in taxable accounts.
• Most 401(k) plans provide quarterly financial statements to help participants track their contributions and investment performance. In addition, most plan providers offer online service on their Web sites via a secured, password protected, Internet connection.
• Early withdrawals of money from a 401(k) before age 59 ½ are subject to a 10% penalty and ordinary income taxes owed for the calendar year of the withdrawal. This will result in a significant erosion of the amount withdrawn, especially if the withdrawal results in taxing income at a higher marginal tax bracket.
• Under certain circumstances, you can withdraw money from a 401(k) without the 10% early withdrawal penalty. They include death, disability, retirement, payment of medical expenses that exceed 7.5% of adjusted gross income, and as a series of roughly equal periodic payments based on life expectancy.
• By participating in a 401(k), you are dollar-cost averaging. This means that you are making regular deposits at regular time intervals (e.g., $100 every two weeks on bi-weekly paydays). Your fixed deposit will buy fewer shares when share prices are high and more shares when prices drop. There is no guarantee, however, that 401(k) investments other than cash assets won’t lose money. Cash assets are subject to inflation risk.
• Putting a high percentage of money in stock, consistent with your risk tolerance level, makes the most sense when workers are younger. As you close in on retirement, consider modifying 401(k) plan selections to increase the amount held in bonds that provide fixed income. Another increasingly popular 401(k) plan option is target date funds, which automatically grow more conservative as workers approach retirement.
