401(k) plans, created by the Tax Reform Act in 1978, were designed to encourage people to save for retirement. Defined contribution plans, including 401(k)s, are so called because the amounts contributed are “defined” by plan participants and/or their employers. In other words, individuals determine how much they want to set aside for retirement.
To encourage people to save for retirement, 401(k) plans offer a number of features that can benefit employees as they save for retirement. These features include:
Pre-tax savings. Money contributed to a 401(k) plan is taken from the employee’s paycheck before taxes are calculated. This is important, because it means more money is going into the account, and the participants are earning returns on the funds that normally would have gone to pay taxes. For example, a person in the 28 percent tax bracket might contribute $200 each month to a 401(k) plan. The full $200 goes into the plan, but the plan participant’s take-home pay only goes down by $144. The taxes will be due when the participant withdraws funds from the plan, but his or her tax rate may well be lower in retirement.
Company matching. Many employers match all or part of an employee’s contributions up to a certain level. If our hypothetical participant is contributing $200 each month, and his or her employer is matching 50 percent of contributions, $300 will go into the 401(k) plan. That means the participant has just saved $300 for retirement, while his or her take-home pay has still gone down only $144. This is why many people describe their 401(k) matching agreement as “free money.”
Tax-deferred compounding. The tax benefits extend to the earnings within the 401(k) account. Any interest or other earnings also accumulate free of taxes, allowing faster growth through compounding. As an example, look at our participant who is contributing $200 each month. Assuming an 8 percent annual return in a taxable account, those funds will have grown to $33,081 at the end of 10 years. In a tax-deferred 401(k), however, our hypothetical investor would have $37,549. If we add in the 50 percent employer match, the total would be $56,324! This is a hypothetical example and is not representative of any specific situation. The hypothetical rate of return used does not reflect any particular investment. Your results will vary.
Investment options. Typically, 401(k) plans feature a range of investment options, such as stock, bond, and money market mutual funds. Many people may not have access to these types of investments on their own, so a 401(k) plan provides them with potential earnings that they may not be able to get in savings accounts. For example, stocks typically have greater return potential than the interest paid by certificates of deposit (CDs) or savings accounts. Stocks also carry higher risks, whereas CDs are FDIC insured and offer a fixed rate return, so plan participants should educate themselves on the risk/return tradeoff and choose investment options with which they are comfortable.
401(k) plans are complex programs, and FiduciaryFirst can help you create a plan that fits the needs of your company and your employees. If you would like our retirement plan consultants to help you develop a solid strategy for your retirement plan, please visit our website at www.fiduciaryfirst.com or call us at 407-740-6111.