Although many will agree that saving for retirement is an excellent financial move, a significant number of employees still do not participate in their employer-sponsored retirement plans. The lack of participation can be the result of having insufficient income to make retirement contributions. However, many times, employees don't participate because they're unaware of the benefits and rules of these plans. Here we look at some of the advantages of making salary-deferral contributions to employer-sponsored plans, such as 401(k)s and 403(b)s.
Tutorial: Retirement Planning
- Many employees don't participate in employer-sponsored retirement plans, due to lack of funds to contribute or lack of information about the benefits of participating.
- Employees who do participate benefit from lower taxable income, from tax-deferred earnings growth, and from deferred taxes.
- Many employers offer an employee-matching fund in which they match a small percentage of what an employee has saved in a retirement fund.
1. It Reduces Your Taxable Income
Contributions to your employer-sponsored plan are usually made on a tax-deferred basis. Tax-deferred 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" and your taxable income for the year is $31,000. If you contribute $2,000 to your 401(k) account, your taxable income will be reduced to $29,000, and the amount of taxes you owe will also be reduced.
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. And the IRS will eventually get its cut of that $2,000 when you withdraw it from the account, as you eventually will have to when you reach a certain age. 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.
2. It Provides Tax-Deferred Growth and Allows You to Defer Taxes
Another benefit of saving with a tax-deferred 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 could affect how much tax 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–which these are–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.)
Employers that provide matching contributions are basically giving you free money.
3. You Get 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 a minimum, you should consider contributing up to the maximum amount your employer will match. Not taking your employer's offer to match contributions means you'll miss out on free money.
Like your own contributions, the matching funds 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:
John works for ABC Company, which agrees to make a matching contribution of 50 cents on every dollar, up to a sum equal to 6% of each employee's compensation. John's compensation is $31,000 per year, of which 6% is $1,860. If John contributes $2,000 from his paychecks throughout the year, John will receive an additional $1,000 contribution 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 contribute $3,720 per year.
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.
The Bottom Line
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 and can afford it, contribute to both an IRA and your employer-sponsored plan. Contributing to your retirement plan helps ensure a financially secure retirement. As always, consult with your tax professional for assistance in making decisions on financial matters.