As a recent graduate entering the workforce, I needed to learn and understand the advantages of employer-related tax-saving opportunities. A previous post discussed FSAs and HSAs. This article will focus on retirement savings plans, specifically, 401(k) plans, as many people know them. Many companies offer this benefit as part of their compensation packages.
Many people just starting their careers may postpone planning for retirement, feeling that they have plenty of time to save later. They have more immediate concerns about how they will pay for student loans, rent, food, and other daily living expenses. Despite these real financial concerns, it is advisable for young professionals to start putting money aside as early as possible to allow the investments to grow and increase in value before retirement.
Retirement savings plans are important to consider, not only for the long-term financial benefit they can provide, but also for the more immediate potential tax savings that can be realized. By maximizing contributions to a qualified retirement savings plan, employees can, in some cases, reduce their taxable income while setting aside a nest egg for the future.
Since the emergence of the 401(k) plan in the late 1970s, they have been a popular vehicle for retirement planning. Understanding the rules that allow taxpayers to take advantage of the tax savings opportunities and strategizing about how to maximize the investment over time, will help ensure that the plan benefits are utilized to their fullest potential.
What Is a 401(k) Plan?
A 401(k) plan is a type of profit-sharing or stock bonus plan to which participants can choose to contribute part of their compensation on a pre-tax basis instead of receiving the pay in cash. This contribution is called an elective deferral because participants elect to set aside the money, and defer the income tax, along with investment gains and losses, until it is distributed to them. When the 401(k) plan is part of a profit-sharing plan, employers have flexibility to make additional discretionary contributions. Employers that cannot afford to make discretionary contributions may still find a 401(k) plan an attractive option to offer employees who wish to contribute on their own. There are many qualifying factors in setting up a company 401(k) plan, along with rules regarding employee deferrals and company contributions. These details, as well as the tax treatment of the plans, need to be discussed with your tax professional, to stay in compliance with all necessary regulations.
Types of 401(k) Plans
There are several kinds of 401(k) plans, two of them are discussed below:
Traditional 401(k) Plan
A Traditional 401(k) plan uses the employee’s pre-tax dollars to contribute to a retirement savings account. These contributions, as well as additional potential contributions from the employer, accumulate in the account, along with earnings on these funds. One of the key benefits of this type of plan is that it immediately reduces taxable income for the employee. At retirement, any withdrawals from the 401(k) balance which includes all contributions, earnings, and employer contributions since its inception, will be taxed at the taxpayer’s individual income tax rates in effect at the time of withdrawal.
Roth 401(k) Plan
A Roth 401(k) uses the employee’s post-tax dollars to contribute to a retirement savings account. These contributions, as well as additional potential contributions from the employer, accumulate in the account, along with earnings on these funds. The benefit of this type of plan is that, at retirement, any withdrawals from the 401(k) balance, which includes all employee contributions and earnings since its inception, will NOT be subject to tax. Any employer contributions will be taxable upon withdrawal.
Choosing the Right 401(k) Plan
Both Traditional and Roth 401(k) plans are great tax-savings options for retirement. The “At-A-Glance” chart below is helpful in discerning the differences and advantages.
|
Traditional 401(k) |
Roth 401(k) |
|
Contributions of up to $22,500 in 2023 |
Contributions of up to $22,500 in 2023 |
|
Additional “catch-up” contribution |
Additional “catch-up” contribution |
|
Income taxes paid on employee contributions are deferred until withdrawal |
Contributions are made with post-tax dollars |
|
Current contributions immediately reduce taxable income and grow tax-free until withdrawal |
Employee contributions and earnings are |
|
Current Required Minimum Distribution Age:73 |
Current Required Minimum Distribution Age: 73 |
|
Early withdrawal (before age 59½) |
Early withdrawal (before age 59½) |
When deciding which type of 401(k) plan to choose, it is important to determine whether it is more favorable to pay taxes now, at your current rate, or wait until later, and pay taxes at the tax rate in effect when you retire.
Note: self-employed individuals can also take advantage of 401(k) plans and other tax-deferred retirement savings options, but discussion of these plans is outside of the scope of this post. Details about these plans can be found at https://www.irs.gov/retirement-plans/retirement-plans-for-self-employed-people.
Potential Tax-Saving Opportunities through 401(k) Plans
Traditional 401(k) Plan
Employee contributions to a traditional 401(k) plan are delineated on your W-2 and will reduce your current taxable wages. Though it may seem like putting money aside for retirement is a luxury you cannot afford, with the immediate tax-savings benefits in effect, many employees see a manageable reduction in their net take-home pay, even after making a significant contribution to their 401(k) plans. This is illustrated in the example below, which assumes the following:
- An individual employee with gross wages of $60,000 elects to make a contribution of 5% to a traditional 401(k) plan
- Effective Federal tax rate assumed at 10%; State tax rate assumed at 3.07%
- FICA/Medicare employee tax rate = 7.65%
- Example excludes any city tax ramifications
Net annual cash to employee without any contribution to a 401(k) plan:
- 60,000 x [1- (.10+.0765+.0307)] = $47,568 or $3,964 per month
Net annual cash to employee with a 5% annual pre-tax contribution to a traditional 401(k) plan:
- $60,000 – $3,000 = $57,000 (amount of taxable income after 5% pre-tax contribution)
- ($57,000 x [1 – (.10 + .0765 + .0307)]) – (3,000 x .0765 FICA/Medicare) – (3,000x .0307 state) = $44,869 (net pay after taxes) or $3,739 per month
- Plus the employee will have $3,000 sitting in a separate, personally owned retirement account at the end of the year
- Net TOTAL Annual Cash to employee with a contribution to a traditional 401(k) plan = $47,869
Roth 401(k) Plan
Contributions to a Roth 401(k) plan, and the corresponding tax benefits, work a bit differently than a traditional 401(k) since taxes are paid up-front on these funds before they are put into the retirement savings plan. An employee’s after-tax cash flow will be reduced, dollar-for-dollar, by the amount of the Roth 401(k) contribution, but the employee will have that amount set aside in a retirement savings account. A tax advisor should be consulted to discuss the tax advantages of these types of plans.
Getting Started
Understanding your current and future financial situations is very important in making these decisions. A financial advisor and/or tax advisor should be consulted, as they can guide you to the best choices for your individual situation. If you would like to discuss how 401(k) plans could be incorporated into your tax planning strategy, please contact your GYF Tax professional at 412-338-9300.
