There are many qualified retirement accounts that people can use to help them save for retirement.  “Qualified Accounts” are those that receive some form of special tax treatment to incentivize us to save.  This article will discuss the main points of a 401k plan.

Section 401 covers qualified pension, profit-sharing, and stock bonus plans.  Section 401k of the Internal Revenue Code provides the foundation for cash or deferred arrangements and is about 10 pages long.  While the Code is rather complex, the gist of Section 401k is that it permits individuals to defer compensation by redirecting a portion of the earned income into a 401k plan on a pre-tax basis, thus lowering your taxable income.

To give a simplistic example, let’s say you earn $50,000 per year.  That would place you in the 25% tax bracket, ignoring all other exemptions and deductions, for 2012.  Putting 10% into your 401k, or $5,000, would effectively save you $1250 in taxes for the year.

While this is a nice benefit, I have been told, “I would rather have the extra $3750”.

But, there is more.  If your company matches your 401k contribution, there is an additional benefit.  While company plans vary, most plans match the first 3% of deferred salary. That would account for an extra %1500 in matching, putting your total contribution for the year at $6500.  Your taxable income is still reduced by the $1250.

This looks like a pretty good way to save some money.  But wait, it gets even better.  Your earnings, assuming there are some, also grow tax deferred, meaning that your dividends and capital gains are not taxed in the year that they occur.  In fact, they don’t really get taxed at all.

The down side is, that when you do take the money at retirement, your account is taxed at the ordinary (earned) income rate.  In effect, it becomes your retirement salary.  Between the match and the deferral you come out ahead.  Besides, it is better than not having a retirement account at all.

Putting $5,000 a year into a 401k plan for 20 years at an 8% average annual return would yield $270,419 versus $210,999 in a taxable account.  (Source:  http://wwwcalcxml.com/calculators).

These numbers reflect the $5000 annual deferral in the example, but does not include the company 401k match !  The after tax factor can be managed to minimize the effects of taxes.  The calculator does not explain how much was distributed or when.  This would be a very nice supplement to social security.

401k plans are easy to set and easy to participate in.

Don’t have a 401k option at work?  Contact us for other options and stay tuned for more articles in this series.

Own a small business and think a 401k plan is out of reach?  While it is true that 401k plans have historically been very expensive to administer, our 401k plans are surprisingly affordable and include all asset management, investment planning, enrollment and administrative, and third-party administrator services.  Contact us for more information.

Own a business without employees?  The individual 401k offers additional deferral possibilities, with minimal administrative requirement, and flexibility.  A must have for the start-up.

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