401(k) plans pack a big tax-savings punchBy Jason Alderman
Managing your personal finances can be a constant juggling act where car payments, a mortgage and college savings all compete with daily expenses. Despite today’s pressing needs, don’t lose site of tomorrow’s top financial priority: your retirement.
Financial planners often speak of the three-legged stool for funding retirement: government-provided benefits, employer plans and personal savings. But with Social Security’s future in doubt and pension plans going the way of the dodo bird, it’s a good idea to depend on your own resources whenever possible.
For millions of Americans whose employers sponsor a 401(k), 403(b) or 457 plan (named for their governing IRS codes), one of the best things they can do to ensure future financial security is to participate in the plan. If you don’t, you’re missing a golden opportunity to save for retirement while lowering your current tax burden. You may also be leaving free money on the table, because many employers will kick in a matching contribution to your account.
With these plans, money is deducted from your paycheck before taxes are withdrawn, lowering your taxable income and therefore, your taxes. You don’t pay taxes on these savings or their investment earnings until you withdraw them – usually at retirement when your taxable income, and tax rate, may be much lower.
It’s also a relatively painless way to save, since the money goes directly to your retirement account, reducing the temptation to spend it. You can usually contribute a percentage of your pay up to the IRS-allowed maximum ($15,000 in 2006), although people over age 50 can make additional “catch-up” contributions of up to $5,000. Many companies will match a portion of your contributions as an incentive to save: A common match is 50 percent of the first 3 percent of pay you save
It really adds up: Say you earn $35,000 and are in the 25 percent marginal tax bracket. Contributing 6 percent of your pay ($2,100) lowers your taxable income to $32,900, reducing income taxes by $525. A 50 percent employer match of the first 3 percent you contribute would add another $525 to your account. In the end, you would pay only $1,050 for $2,100 in annual savings, or $87.50 a month. Saving that same $2,100 in a traditional savings account would cost $175 a month.
The sooner you start saving, the faster your account will grow. Conversely, the longer you wait, the harder it is to catch up. Some experts say for every five years you delay, you may need to double your monthly savings amount to achieve the same retirement income.
Plans usually provide various investment options such as stock, bond and money market mutual funds. And while most withdrawals before age 59 ½ face severe tax penalties, many plans offer loan provisions in case you need money for a housing down payment or an emergency. Just be careful, because you must fully pay back the loan if you quit your job, or risk penalty fees.
The Motley Fool provides an informative (occasionally tongue-in-cheek) overview on 401(k) plans www.fool.com/money/401k. Another good source is Practical Money Skills for Life, a free personal financial management site sponsored by Visa Inc. www.practicalmoneyskills.com/401k, which contains detailed retirement financial planning information, including interactive online calculators for estimating your retirement needs.
Remember, don’t get so caught up in today’s needs that you forget about tomorrow’s.
Jason Alderman directs the Practical Money Skills for Life program for Visa Inc. More information about retirement planning and other financial tips can be found at www.practicalmoneyskills.com. As always, consult a financial professional regarding your particular situation.
This article is intended to provide general information and should not be considered tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how tax laws apply to your situation and about your individual financial situation.<< Back to Practical Money Matters