Once eligible, you contribute to the 401(k) Plan through payroll deduction. These contributions are “pre-tax,” that is, they are deducted from your gross income before federal and state taxes are calculated. Generally, your gross earnings, including regular pay, overtime, bonus, etc. is considered when figuring the amount of your 401(k) contribution.
When computing your federal and state taxes, your 401(k) contributions are deducted from your gross earnings. Social Security taxes are paid on your gross salary (including 401(k) deferrals). Therefore, your Social Security taxes and benefits are not affected by your 401(k) participation. By contributing pre-tax, the government actually pays you to save by reducing the taxes you pay.
Your employer will have you complete an election form specifying the percentage of your gross salary you want to contribute to the 401(k) plan. Some Plan Sponsors allow on-line enrollment or by phone.
Most Plans usually specify certain percentage limits on what you can contribute. For example, a lot of plans allow you to contribute between 1% and 15% of your gross salary. These plan restrictions may be removed in the near future, because in 2002, the law changed to allow employees to contribute up to 100% of your salary. In addition to your Plan’s limits the IRS places a cap on the maximum dollar amount you can contribute in a calendar year. Beginning in 2002, an additional pre-tax catch-up contribution can be made if you are age 50 or older.
| Calendar Year | Dollar Maximum | Additional Amount Age 50 or Older |
|---|---|---|
| 2001 | $10,500 | N/A |
| 2002 | $11,000 | $1,000 |
| 2003 | $12,000 | $2,000 |
| 2004 | $13,000 | $3,000 |
| 2005 | $14,000 | $4,000 |
| 2006 | $15,000 | $5,000 |
As you can see, this new law increases the maximums so that almost everyone can contribute as much as they want.
Yes!
The federal and state governments provide tax incentives to encourage you to save for your retirement. That is:
- You don’t pay federal and state tax on your contributions when they are made to the 401(k) Plan, and
- You don’t pay federal and state tax on the investment earnings on your 401(k) savings as they accumulate for your retirement.
Because your contribution and the investment earnings are not currently taxed, you pay less federal and state taxes. In other words, the federal and state governments actually pay you to save. Because your account compounds tax deferred, you can build savings faster in the 401(k) Plan.
Look at the value of the tax deferred advantage:
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The taxes you save by contributing to the 401(k) Plan depend on your income tax bracket. Your income tax bracket is the percentage of taxes you pay on your last dollar of income. That is, your 401(k) contributions are taken “off the top” of your salary which is the highest tax rate you pay – your income tax bracket.
| Tax Bracket | Single | Married |
|---|---|---|
| 10% | Up to $6,000 | Up to $12,000 |
| 15% | $6,000-$37,950 | $12,000-$46,700 |
| 27% | $27,950-$67,700 | $46,700-$112,850 |
In addition to federal tax you also save on your state tax. State taxes vary widely from state-to-state. For the following example we assume your state tax rate is 4%.
Let’s look at an example. Assume you are single, make $24,000/year and save 6% of your salary. Here’s what it looks like:
| No Contribution | 6% Contribution | |
|---|---|---|
| Your Annual Salary | $24,000 | $24,000 |
| 401(k) Savings | ---- | 1,440 |
| Your Taxable Income | $ 24,000 | $ 22,560 |
| Taxes You Pay | ||
| *Federal Tax (10% on first $6,000 and 15% thereafter) | 3,300 | 3,084 |
| *State Tax (4%) | 960 | 902 |
| *Social Security Tax | 1,836 | 1,836 |
| Total Taxes You Pay | 6,096 | 5,822 |
| Net Income | 17,904 | 16,738 |
| 401(K) Savings | ---- | 1,440 |
| Net Income (Including Savings) |
$ 17,904 | $ 18,178 |
| Tax Savings | $ 274 |
Take advantage of the IRS’s tax rules and let the government pay you to save for retirement.
As soon as possible!
The old saying, “Time is money” is right on target when applied to your retirement savings. Retirement funds grow geometrically on a tax-preferred basis. Geometric growth means that your account grows at an ever-increasing rate. Albert Einstein called this geometric compounding the eighth wonder of the world because the longer period of time your money is invested the steeper the curve gets. The steeper the curve gets the more money you make.
Because, the longer you can keep your money invested, NOW is the time to begin – It’s the first day of the rest of your life. The following example demonstrates both the geometric growth and the advantage of starting early.
| Example |
Both John and Bob are 25 years old
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John, at age 25, starts saving immediately $2,000 a year but stops after only 10 years, a total of $20,000 in contributions. |
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Bob waits 10 years until he’s 35, but then he contributes $2,000 a year all the way to 65, making 30 years of contributions, a total of $60,000 in total contributions. |
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Don’t procrastinate! Pay yourself first and reap the rewards of beginning your retirement savings program as soon as possible.
No! The only contributions you can make must be by automatic payroll deduction before you are paid. This preserves the tax savings due to “pre-tax” treatment of your contributions. You cannot add money to the plan by writing a personal check.
If you want to increase your contributions, you must increase the percentage of salary you are having withheld through your payroll department or on-line if your company allows you to do so.
First you have to check with your old employer to see if you are entitled to a distribution. If so, you must complete forms from your old employer to either receive a cash distribution or directly rollover your benefits to your new company’s plan. It is very important to directly rollover your benefit to avoid current tax and possible penalties.
Once the distribution forms from your old plan are completed, your old plan will directly transfer your benefits to your new company’s plan. Be sure to tell the new plan how you want your funds invested.
Some plans allow for rollovers regardless of whether or not you have met the initial eligibility requirements. Check with your benefits specialist.