Salary Reduction Plans
If you want to diversify your retirement investments, 401(k)s, 403(b)s, and 457 plans may be one way to do it.
Salary reduction plans are the best known defined contribution plans.
These 401(k)s, 403(b)s, and 457s -- their catchy names refer to the sections of the tax code that describe them -- are also increasingly the only game in town -- or at least the only way many employees can participate in a retirement plan.
How Salary Reduction Works
You invest using a salary reduction plan by having a percentage of your salary deposited in your plan account. The amount you deposit is deferred income -- it does not count as part of your taxable income for that year.
Employers who offer salary reduction (or salary deferral) plans arrange for you to invest your money in different fixed income, equity, or money market accounts. You choose among the options, and pay the costs of investing, such as administrative fees. But you do not have to pay any tax on your contributions to these funds or their earnings until you withdraw from the account.
Remember, though, that the return on the investments you select will fluctuate, and your account may lose value in some years.
What You Can Contribute
The maximum amount you can contribute to a salary reduction plan is set each year by Congress and by your employer. The government caps the dollar amount, while your employer may impose a restriction measured as a percentage of your salary.
For 2009, for example, you can contribute up to a maximum of $15,500 to a 401(k), 403(b), or 457 plan and up to $11,500 to a SIMPLE.
If you're 50 or older, you can make additional contributions each year, up to the cap set by Congress, to boost your account value. In 2009, you can add an extra $5,500 to a 401(k) or similar plan and $2,500 to a SIMPLE.
A Double Plus
The double benefit of these tax-deferred plans is saving on your
tax bill and investing for retirement at the same time. For
example, if you're single, make $75,000, and put 8% of your salary
in a 401(k), 403(b), or similar plan you'll pay less in federal
income taxes, and you'll have $6,000 with the potential to grow tax
deferred.
| The more money you put in a 401(k) plan… | With a 401(k) Plan | Without a 401(k) Plan |
|
You save on taxes while you invest for retirement. |
You pay more in tax and you must set aside savings from income after tax. | |
|
the lower your taxable salary… |
$75,000 |
$75,000 |
|
the less tax you pay… |
$11,100 *Taxes on $59,650 taxable income * Tax at 2009 rates, single taxpayer, including personal exemption and the standard deduction. |
$12,600 *Taxes on $65,650 taxable income * Tax at 2009 rates, single taxpayer, including personal exemption and the standard deduction. |
|
and the faster your investment grows. |
$6,000 returning 8% tax- deferred will grow to $7,560 after 3 years, and $12,960 after 10 years |
Nothing invested to grow tax deferred and $1,500 more due in federal taxes. State income taxes may also apply. |
The 400 Family
While 401(k)s are the best known of the salary reduction plans, they're just one of a group of plans available to people who work for different types of organizations.
They may also play different roles in retirement planning. 401(k)s, for example, are often the primary way for corporate employees to participate in a retirement plan. The same is true for state-sponsored 457 plans. In contrast, 403(b)s may be offered in addition to defined benefit pensions provided by not-for-profit employers.
Each of these plans, while available only to a specific group of workers, has the same annual contribution maximum. And while the plans operate under different rules, you have the right to move assets you accumulate in one type of plan into another of the plans if you change jobs and your new employer allows such rollovers.
Employers who offer tax-deferred 401(k) or 403(b) plans have the option of allowing their employees to make after-tax contributions to a Roth account. The same annual contribution limit -- $15,500 in 2009 -- applies, but contributions do not reduce the employee's current taxable income. The attraction, however, is that eventual withdrawals are tax free if the employee follows the rules for withdrawal. Some employees also allow their plan participants to split their contributions between tax-deferred and Roth accounts.
When a 403(b) is Not a 403(b)
If you work for an academic institution or other not-for-profit, you may not recognize the name 403(b), even if you're participating in one. Salary reduction plans are frequently known by other names, including tax-sheltered annuities (TSAs) or tax-deferred annuities (TDAs), especially when they're offered as supplements to defined benefit plans.
Source: Copyright 2009 Lightbulb Press, Inc. All Rights Reserved.
Disclaimer: This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.
Copyright© 2010; Lightbulb Press, Inc. All Rights Reserved.
