401(k) Plans
A 401(k) Plan offered by an employer to employees is a terrific employee benefit – enabling an employee to annually contribute as much as $17,500 (for 2013), and catch up contributions if age 50 or over, to his or her plan instead of the limit of $5,500 to an IRA. All of that money is pre-tax – not includible in gross income for current income tax purposes. In addition, the employer may also offer an employer matching contribution – perhaps as much as 50% of the first 6% of employee contributions. Think of it – if you’re an employee, that’s an immediate 50% return on your employee deferrals – FREE money! Yet time and again, many younger employees fail to participate in these plans with all kinds of excuses – they have plenty of time before needing to worry about retirement, they are going to enjoy their incomes, have fun, party, buy cars, etc. Nothing could be further from the truth. Time is on their side now, especially because of the magic of compounding!
Compounding – What is It?
Very simply, compounding means that you earn income on your income. In year 1, if you start with $10 of investment and earn an 8% return on your investment, at the end of the year 1 you will have $10.80. If you contribute another $10 at the beginning of year 2 you will have earned the 8% on the $10.80, or $.86 and an additional $.80 on the $10 contribution, and have $22.46 at year end, and so forth. The longer the money is invested, the more you have. So, who does compounding benefit the most? The participants with the mosttime – the younger employee. Let’s look at an example which might surprise you.
A, B and C are fresh college graduates at age 21, and employed by XYZ Corporation. XYZ offers a 401(k) plan to its employees with immediate eligibility, but no matching employer contributions. A and B decide to participate in the plan immediately, while C says to himself – “I’ve got plenty of time to worry about retirement” and does not participate. Ten years go by. A continues to participate until retirement age at
65. B has married, has a house and kids and decides he needs to stop participating because he could use the extra money now. C decides that now is a good time to start participating, and does so until retirement at age 65. Assume each earns $50,000 a year and contributes 10% a month to the plan while participating, and earns 8% on investments in the plan. At age 65, who has the most money? Who has the least? Let’s have a look. The results may surprise you.
Contributions | Earnings | Total | |
---|---|---|---|
A | $220,000 | $1,804,504 | $2,024,504 |
B | $55,000 | $1,163,861 | $1,218,821 |
C | $170,000 | $ 707,744 | $ 877,744 |
Well, clearly A has the most – having contributed $5,000/year for 44 years and earning 8% on that money – a total of $2,024,504. And, surprisingly, B has more than C, even though B only contributed for 10 years and stopped, and C contributed for 34 years. B contributed $55,000 and earned $1,163,861 for a total of $1,218,821, and C contributed $170,000 and earned $707,744 for a total of $877,744.
The secret to B having more money is his early contributions to the plan and compounding of interest.
If you’re a business owner, why is this good for you? One of the problems many business owners face with their 401(k) plans is that they fail compliance testing for deferral percentages – the actual deferral percentage (ADP) for highly compensated employees exceeds the ADP for the non- highly compensated, most likely the newly hired younger employee, by more than 2% – usually because the younger employees are not participating and tested at 0%. This failure may prevent higher paid managers and executives from contributing the maximum to the plan. The solution may simply be in the form of better educating the younger employees about the benefits of early participation and compounding of returns.
Compounding earnings – time – something the younger employees have to their advantage in planning for retirement, and something that, if well communicated, can help out the business owner in providing a sound employee benefit to attract and retain employees through a qualified retirement plan that all employees can take advantage of.
Time to Convert to a Roth 401(k)?
The new legislation expands a 2010 law that gave workers investing through so-called defined-contribution
plans such as 401(k)s the leeway to roll pretax savings and employer contributions into Roth accounts within
their plans. The attraction: After paying an upfront tax bill, future earnings and retirement withdrawals generally would be tax-free.
The 2013 tax laws present a host of opportunities and pitfalls for those converting pre-tax retirement savings to tax-free retirement savings. Make one wrong move and it can literally cost you dearly. Both in-plan conversions of pre-tax 401(k) savings to tax-free Roth 401(k) savings and conversions of Traditional IRAs to Roth IRAs can generate taxable income for most taxpayers. The converted amounts are treated as additional income when you file your taxes.
That additional income can push you into the top 39.6% marginal income tax bracket and the top 20% rate on
long-term capital gains and dividends for those making $400,000 (single) or $450,000 (couples). It could also
push you into the personal exemption and deduction phase-out category for those making $250,000 (single) or $300,000 (couples). It could also subject you to the 3.8% investment surtax on interest, dividends and capital gains for those making $200,000 (single) or $250,000 (couples). Importantly, most of these taxes are cumulative at the incremental income levels. Fortunately, converting in measured increments can avoid unnecessary taxes.
The foregoing information regarding estate, charitable and/or business planning techniques is not intended to be tax, legal or investment advice and is provided for general educational purposes only. Neither Guardian, nor its subsidiaries, agents or employees provide tax or legal advice. You should consult with your tax and legal advisor regarding your individual situation.Data and rates used were indicative of tax rates and information available on the date written.