What is a 401K Plan?
The tax laws under section 401K of the Internal Revenue Code allow an employee to defer a portion of his or her compensation into a retirement plan. This reduces taxable income today, saving taxes. The amount deferred is invested by the plan, usually in mutual funds, so it will grow to provide benefits for retirement. The deferred money and the income it earns are subject to tax later, when the employee takes his or her retirement funds out of the deferred-tax investment.
This is the only tax shelter available to most people. Earn money today; defer the receipt and benefit until retirement years.
When compensation is deferred, the amount deferred from each paycheck is removed from the take-home pay and transferred into the retirement account. The immediate impact is that take-home pay has decreased. Employees must determine how much they can afford to decrease their take-home pay and elect an appropriate percentage of their pay to defer.
Here’s a sample employee scenario:
Gross annual pay – $52,000
Weekly pay – $1,000
Deferral Election – 5% ($50/week, $2,600/year)
Taxable income will be $49,400 for the year ($52,000 – $2,600)
Federal taxes saved will be approximately $500 depending on filing status.
Future accumulation based on $50/week for 40 years at 5% interest = $332,000
What does a company match mean?
Generally, employees should defer the maximum amount they can afford. To encourage employees to participate and defer more, many companies offer a matching program that provides extra benefits to employees. The company will contribute to the employee’s account a percentage of the amount the employee contributes. The company gets a tax deduction for its match and the employee receives a real benefit.
For example, one company’s matching formula may be that it makes a matching contribution equal to 50% of the participating employee’s salary deferral contributions, limited to the first 3% of the participating employee’s eligible compensation calculated on a pay-period basis. In this example, on an annual basis the matching contribution would equal $1,300 limited to $1,560 (3% x 52,000), or $1,300. Thus, the employee invests $2,600 plus $1,300 of company match or a total of $3,900 annually. Now the future accumulation approximates $498,000 based on $75/week for 40 years at 5% interest.
How does vesting affect benefits?
Deferral money, and related investment earnings, is always owned 100% by the employee. However, matching money contributed by the company may be subject to vesting. Vesting means that the employee will own a percentage of the company’s contribution that will increase every year until the employee is employed long enough to own all of it. Most vesting usually takes three to five years of service for the employee to own 100% of the matching contributions plus earnings. If an employee leaves the company when he only owns 60% of the matching contributions, then he would receive 100% of his own deferral money plus accumulated income and 60% of the matching funds plus accumulated income. The other 40% would be forfeited and stay with the plan.
What’s the maximum deferral amount?
For 2018, the maximum deferral amount was $18,500 and for 2019 it is $19,000. An individual that was at least 50 years of age in 2018 could defer an additional $6,000 for 2018 and for 2019 can defer an additional $6,000 (known as catch-up contributions).
I recommend that everyone should take advantage of 401K plans. The cost of administering the plan can be paid by the company that sponsors the plan or by allocating the cost to the participants in the plan. Determine how much you can afford to defer. Try to maximize the amount of the company match if there is one.
The match can be discretionary so the company can decide annually if profits enable them to provide a match. Start saving for retirement.
James M. Sausmer recently retired from Mazars USA LLP as a Partner and is currently directing the audits of 401K plans for Rizick & Rizick CPAs, LLC. Contact Jim.