Making Salary Deferral Contributions - Part 1 of 2
By Denise Appleby
Although many will agree that contributing to a retirement plan is a good financial
decision, a significant number of employees still do not participate in their employer
sponsored retirement plan. This lack of participation is often the result of a misunderstanding
of the rules or an unawareness of the benefits. So let's discuss some of the advantages
of making salary-deferral
contributions to employer sponsored plans.
Reduction of Taxable Income
Salary-deferral contributions to your employer sponsored plan are usually made
on a tax-deferred basis.
This means that your taxable income for the year is reduced by the amount you contribute
to the plan. For example, say that your tax filing status is 'single', your taxable
income for the year is $31,000, and the amount of income tax you owe is about $4,488
(based on 2004 rates). If you make a pre-tax salary-deferral contribution of $2,000
to your 401(k) account, your taxable income will be reduced to $29,000, and the
amount of taxes you owe will be $3,993, resulting in a tax reduction of $495. (For
a list of tax rates, see IRS publication 505, available at www.irs.gov.)
Of course, an individual's tax reduction depends on the amount deferred and the
tax bracket within which his or her taxable income falls; therefore, the tax savings
are not the same for everyone. In the example above, you will eventually need to
withdraw the $2,000 you deferred. But if you refrain from withdrawing it until you
retire, when you are likely in a lower tax bracket, you will pay less tax on the
$2,000 than you would've paid had you not chosen to defer it to your retirement
account.
Tax Deferred Growth and Deferment of Paying Taxes
Another benefit of saving with a qualified retirement
plan is that the earnings on investments are also tax-deferred. This means
that you will not pay taxes on your earnings, regardless of their value, until you
make a withdrawal from the plan. You therefore have some control over when you pay
taxes on those earnings, which in turn affects how much taxes you pay.
For instance, you can choose to make withdrawals in years when your income is lower,
which may mean, again, that you are in a lower tax bracket. On the other hand, if
you chose to invest the amount in an account that is not tax-deferred, you would
owe taxes on the earnings the year the earnings are accrued. (Usually, an individual
is allowed to make withdrawals from a qualified plan only after meeting certain
requirements, as defined under the plan. In addition, Required
Minimum Distribution (RMD) rules will apply, which will dictate some withdrawal
options.)
Example 1
John's taxable income for the year is $31,000, and he wants to save $2,000 towards
his retirement. John is deciding whether to deposit the amount to a certificate
of deposit (CD) with post-tax assets or to make a pre-tax salary deferral contribution
to his 401(k) account. To see which choice is better, we ran the following illustration
(assuming a fixed rate of return of 4% APY for both options for a period of five
years):
|
Year
|
CD Option
|
Comments
|
Salary Deferral Option
|
Reinvested Amount
|
|
|
Invested Principle
|
Interest
|
The assumption is that John will reinvest the earnings. But if John has no other
source to pay taxes on the earnings, he may very likely use some of the interest
to pay the taxes due. This would reduce the amount John has available to reinvest,
and reduce his overall earnings.
Over the five-year period, John will have paid taxes on the earnings, reducing his
disposable income.
|
Invested Principle
|
Interest
|
The earnings will be reinvested and will be tax-deferred.
This tax-deferred contribution will reduce John's income tax for the year and increase
his disposable income at retirement.
Taxes will be paid only when the amount is withdrawn from the retirement plan, which
will likely be when John retires and is in a lower tax bracket, thereby reducing
his overall income tax.
|
|
1
|
$2,000
|
80
|
$2,000
|
80
|
|
2
|
$2,080
|
83
|
$2,080
|
83
|
|
3
|
$2,163
|
87
|
$2,163
|
87
|
|
4
|
$2,251
|
90
|
$2,251
|
90
|
|
5
|
$2,341
|
94
|
$2,341
|
94
|
Receiving Employer Matching Contributions - Free Money
Many employers include matching-contribution
provisions in 401(k), SIMPLE IRA and other salary deferral feature plans. If you
are a participant in such a plan and you are not making salary-deferral contributions,
you could be losing the benefits offered by your employer. At minimum, you should
consider making salary deferrals up to the maximum amount your employer will match.
Contributions from your employer accrue earnings on a tax-deferred basis and are
not taxed until you withdraw the amount from your retirement account. Let's look
at another example examining John's situation:
Example 2
John works for ABC Company, which agrees to make a matching contribution of $0.50
on every dollar, up to 6% of each employee's compensation. John's
compensation is $31,000 per year, of which 6% is $1,860. If he defers $2,000, John
will receive an additional $1,000 to his 401(k) account from ABC Company (50% of
$2,000). If John wants to receive the maximum 6% of his compensation ($1,860) that
ABC would contribute to his 401(k) account, John must defer $3,720.
Had John chosen not to make any salary-deferral contributions, he would lose not
only the opportunity to reduce his taxable income and the benefit of tax-deferred
growth, but also the matching contribution from his employer.
Conclusion
As you can see, there are many benefits to making salary-deferral contributions
to your employer sponsored plan. If your employer does not offer a plan with such
a feature, consider funding an IRA instead. Or, if you have the option, do both
if you can afford to. Contributing to your retirement plan can help ensure a financially
secure retirement. As always, consult with your tax professional for assistance
in making decisions on financial matters. In
part 2,
we look at overcoming barriers you might see to making salary-deferral contributions.