Although many will agree that saving for retirement is a good financial move, a significant number of employees still do not participate in their employer sponsored retirement plans. This lack of participation is often the result of a misunderstanding of the rules or ignorance of the benefits. 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
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" 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. (To read about other tax deductions you may qualify for, see 10 Most Overlooked Tax Deductions.)
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.
Note: Salary deferral contributions to non-IRA based plans, including designated Roth Accounts, can also be made on an after-tax basis. In such cases, these contributions do not reduce taxable income.
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 Distributio (RMD) rules will apply, which will dictate some withdrawal options.)
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 after-tax funds 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 rate of return of 4% APY for both options for a period of five years):
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 contributing up to the maximum amount your employer will match. Not taking taking your employer's offer to match contributions is just plain dumb. (Read about some other moves that'll sabotage your savings in 5 Retirement-Wrecking Moves.)
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 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.
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 helps ensure a financially secure retirement. As always, consult with your tax professional for assistance in making decisions on financial matters.