Advantages Of Having A 401k Plan
Having good and/or adequate financial means during retirement becomes an important factor to all employees at some point in their working career. The United States government currently offers Social Security Benefits to retirement age citizens to supplement their retirement income. However, Social Security Benefits are not guaranteed to be available for people who become of retirement age in the upcoming years. This is one of the many reasons to consider alternative savings plans to fund retirement. The 401(k) plan is a retirement savings plan sponsored by an employer. Employee 401k contributions are automatically deducted from the employee’s paycheck each pay period. This money is taken out before the paycheck is taxed. The contributions
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are invested at the employee’s direction into one or more funds provided in the plan. Employers often "match" employee contributions, but are not required to do so. While the investments grow in the employees 401k account, they do not pay any taxes on it. Taxes aren’t paid until the money is withdrawn from the account. The 401(k) plan is named for the section of the tax code that it is governed by. The 401 (k) plan arose during the 1980s as a supplement to pension plans and has become the single largest source of retirement savings. The ultimate value an individual 401(k)
Dixon 2 account depends on so many things such as how much money the employee makes, how much is saved, how long the money was saved before you retirement and how well the stock market performs over that period of time. For people who do not have the time or the financial knowledge needed to properly manage their 401(k) it becomes a daunting task. Moreover, not properly managing their 401 (k) plan can lead to improper use and abuse of the plan. On the other hand, by properly managing the plan well and avoiding the plan abuses a 401(k) plan is one of the most powerful tools to save for retirement. 401(k) plans are named after the section of the Internal Revenue Code in which they appear, and apply to private sector employers. However, the original provision did not allow for a separate account to be set up and funded through salary reductions. “The accidental birth of the 401(k) can be credited to Ted Benna. In 1980, the benefits consultant used his interpretation of the law to create a 401(k) plan for his own employer, The Johnson Cos. that allowed full-time employee’s to fund accounts with pre-tax dollars and matching employer contributions. Benna then asked the Internal Revenue Service to change some proposed rules under the law that ultimately led to the widespread adoption of 401(k) plans by employers in the early 1980s.” (Nasdaq) The contribution percentage amount of pay to the 401(k) plan, immediately decreases the amount of taxes paid. The contribution amount is deducted from the paycheck before income taxes are deducted. That makes the taxable income less, which in turn lowers the employee’s tax bill. Thus, the taxes are deferred or postponed on the income tax 401(k) savings portion and any investment earnings that accumulate until the funds are withdrawn at retirement. For many
Dixon 3 people, their income and income tax rate is lower at retirement.
Therefore, they end up paying a smaller amount of tax on the money. The 401 (k) plan is not synonymous with a pension plan nor was the plan intended to be a replacement as a pension plan for employees. The advantages of having a 401(k) plan outweigh those of having a pension plan. The biggest difference between a 401(k) plan and a traditional pension plan is the distinction between a defined benefit plan and a defined contribution plan. Defined benefit plans, such as pensions, guarantee a given amount of monthly income in retirement and place the investment risk on the plan provider. Defined contribution plans, such as the 401(k) plan allows individual employees to choose their own retirement investments with no guaranteed minimum or maximum benefits. The employees assume investment risks in defined contribution plans. A pension plan presents individual employees with a significantly lesser amount of market risk than 401(k) plans. However, the 401(k) plan offers more flexibility and control to the employee. Pension plans have a pre-determined …show more content…
amount. With a 401k, the employee chooses how much or little they want to contribute to the plan. Loans can be taken for mortgage down payments, hardships, and educational expenses. A 401 (k) plan allows certain amounts to be borrowed which is not an options with a pension plan. Legally, 401(k) money can be accessed as early as 55 under certain considerations. When compared to a pension versus 401k plan, this can be a big advantage when not being eligible for a full pension benefit for any age under 59-1/2. Lastly, pensions only allot a certain amount to be paid out on a monthly basis whereas with a 401k, the amount is decided by employee.
Dixon 4
However, much caution should be used when determining the amount to prevent taking out too much too soon and risk running out of money. The 401(k) plan was designed with some great tax advantages benefits. Plan contributions are come directly out of the employee’s salary. Since the contributions are made with pre-tax dollars, employers do not include these amounts in taxable income for the year. At the end of the year, when the W-2 is generated the W-2 form shows the earnings and wages subject to federal income. The taxes will be lower because of the 401(k) plan contributions made throughout the year. Since the wages are not counted in taxable income there is no requirement to take a deduction when filing your yearly tax return. However, the savings experienced from the 401(k) contributions can be determined from using the calculations from the yearly tax return. For example, using a contribution of $8,100 made to a 401(k) during the year and would be taxed in the 33 percent bracket if included in taxable income, then the tax savings is $2,673. Another tax saving 401(k) plan contributions offer is a reduction in the amount of income tax withholding each pay period. Each pay period employers withhold money for federal income taxes based on the expected taxable income. However, the 401(k) plan contributions amount is not subject to withholdings and will decrease since the taxable income thus making it less than the actual salary. The result is more take home pay each pay period. In addition, the IRS offers a Savers Credit on the contributions to a 401(k) plan. The Savers Credit is applied to the Adjusted Gross Income (AGI). This credit offers a dollar-for-dollar reduction of the individual federal income tax bill. Dixon 5
Tax deferment is an attractive selling point for opting to contribute to a 401(k) plan.
Many economists suggest the tax savings referenced are not really savings at all. In an article found in the fiduciary News and written by Christopher Carosa, he reports,” veryone agrees if the tax rate is lower, then saving in a tax-deferred vehicle like a 401k is a good idea. There are many who believe it’s a wash if the tax rate is the same and a bad idea if the tax rate is higher.
There’s an easy way to test this hypothesis. We took a simple example where an employee contributes $100 per month. This employee is in a 15% income tax bracket and at 15% capital gains tax bracket. We then calculated growth over three time periods: 10 years, 20 years and 30 years. We then compared the taxes and savings for two scenarios: One where all the savings was after tax and one where all the savings was pre-tax. Here’s what we found assuming an 8% growth rate:

Dixon 6
This certainly dispels the myth that remaining in the same tax bracket is a wash, albeit in an ironic fashion. In all three time periods, the employee would pay more taxes using the tax-deferred vehicle, yet, the employee also ends up with more money. We changed the growth rate and found this relationship remained the same all the way down to a 0% growth rate. Only in this special case of no growth is there no difference between saving after tax and saving in a tax-deferred account. The likelihood of assets not growing over these extended time periods is virtually non-existent. The worst ten-year period still produced (slightly) positive growth.” (Carosa, CTFA). Carosa’s test clearly shows the tax benefit of 401(k) contributions. Saving any amount of money towards retirement is good. However, when possible every effort should be made to contribute the maximum amount allowed amount into the employer retirement plan. Saving now significantly increases retirement savings. When contributing the maximum to a 401 (k) plan qualifies your contributions to the maximum employer matching benefit. This is essentially free money. Retirement income of all kinds gets a pass in seven states. Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming have no state income tax. Most states offer some type of retirement-income exclusion, though some are more generous than others. Mississippi, for instance, exempts all retirement income, including public and private pensions and distributions from retirement accounts, such as IRAs and 401(k) s.
are invested at the employee’s direction into one or more funds provided in the plan. Employers often "match" employee contributions, but are not required to do so. While the investments grow in the employees 401k account, they do not pay any taxes on it. Taxes aren’t paid until the money is withdrawn from the account. The 401(k) plan is named for the section of the tax code that it is governed by. The 401 (k) plan arose during the 1980s as a supplement to pension plans and has become the single largest source of retirement savings. The ultimate value an individual 401(k)
Dixon 2 account depends on so many things such as how much money the employee makes, how much is saved, how long the money was saved before you retirement and how well the stock market performs over that period of time. For people who do not have the time or the financial knowledge needed to properly manage their 401(k) it becomes a daunting task. Moreover, not properly managing their 401 (k) plan can lead to improper use and abuse of the plan. On the other hand, by properly managing the plan well and avoiding the plan abuses a 401(k) plan is one of the most powerful tools to save for retirement. 401(k) plans are named after the section of the Internal Revenue Code in which they appear, and apply to private sector employers. However, the original provision did not allow for a separate account to be set up and funded through salary reductions. “The accidental birth of the 401(k) can be credited to Ted Benna. In 1980, the benefits consultant used his interpretation of the law to create a 401(k) plan for his own employer, The Johnson Cos. that allowed full-time employee’s to fund accounts with pre-tax dollars and matching employer contributions. Benna then asked the Internal Revenue Service to change some proposed rules under the law that ultimately led to the widespread adoption of 401(k) plans by employers in the early 1980s.” (Nasdaq) The contribution percentage amount of pay to the 401(k) plan, immediately decreases the amount of taxes paid. The contribution amount is deducted from the paycheck before income taxes are deducted. That makes the taxable income less, which in turn lowers the employee’s tax bill. Thus, the taxes are deferred or postponed on the income tax 401(k) savings portion and any investment earnings that accumulate until the funds are withdrawn at retirement. For many
Dixon 3 people, their income and income tax rate is lower at retirement.
Therefore, they end up paying a smaller amount of tax on the money. The 401 (k) plan is not synonymous with a pension plan nor was the plan intended to be a replacement as a pension plan for employees. The advantages of having a 401(k) plan outweigh those of having a pension plan. The biggest difference between a 401(k) plan and a traditional pension plan is the distinction between a defined benefit plan and a defined contribution plan. Defined benefit plans, such as pensions, guarantee a given amount of monthly income in retirement and place the investment risk on the plan provider. Defined contribution plans, such as the 401(k) plan allows individual employees to choose their own retirement investments with no guaranteed minimum or maximum benefits. The employees assume investment risks in defined contribution plans. A pension plan presents individual employees with a significantly lesser amount of market risk than 401(k) plans. However, the 401(k) plan offers more flexibility and control to the employee. Pension plans have a pre-determined …show more content…
amount. With a 401k, the employee chooses how much or little they want to contribute to the plan. Loans can be taken for mortgage down payments, hardships, and educational expenses. A 401 (k) plan allows certain amounts to be borrowed which is not an options with a pension plan. Legally, 401(k) money can be accessed as early as 55 under certain considerations. When compared to a pension versus 401k plan, this can be a big advantage when not being eligible for a full pension benefit for any age under 59-1/2. Lastly, pensions only allot a certain amount to be paid out on a monthly basis whereas with a 401k, the amount is decided by employee.
Dixon 4
However, much caution should be used when determining the amount to prevent taking out too much too soon and risk running out of money. The 401(k) plan was designed with some great tax advantages benefits. Plan contributions are come directly out of the employee’s salary. Since the contributions are made with pre-tax dollars, employers do not include these amounts in taxable income for the year. At the end of the year, when the W-2 is generated the W-2 form shows the earnings and wages subject to federal income. The taxes will be lower because of the 401(k) plan contributions made throughout the year. Since the wages are not counted in taxable income there is no requirement to take a deduction when filing your yearly tax return. However, the savings experienced from the 401(k) contributions can be determined from using the calculations from the yearly tax return. For example, using a contribution of $8,100 made to a 401(k) during the year and would be taxed in the 33 percent bracket if included in taxable income, then the tax savings is $2,673. Another tax saving 401(k) plan contributions offer is a reduction in the amount of income tax withholding each pay period. Each pay period employers withhold money for federal income taxes based on the expected taxable income. However, the 401(k) plan contributions amount is not subject to withholdings and will decrease since the taxable income thus making it less than the actual salary. The result is more take home pay each pay period. In addition, the IRS offers a Savers Credit on the contributions to a 401(k) plan. The Savers Credit is applied to the Adjusted Gross Income (AGI). This credit offers a dollar-for-dollar reduction of the individual federal income tax bill. Dixon 5
Tax deferment is an attractive selling point for opting to contribute to a 401(k) plan.
Many economists suggest the tax savings referenced are not really savings at all. In an article found in the fiduciary News and written by Christopher Carosa, he reports,” veryone agrees if the tax rate is lower, then saving in a tax-deferred vehicle like a 401k is a good idea. There are many who believe it’s a wash if the tax rate is the same and a bad idea if the tax rate is higher.
There’s an easy way to test this hypothesis. We took a simple example where an employee contributes $100 per month. This employee is in a 15% income tax bracket and at 15% capital gains tax bracket. We then calculated growth over three time periods: 10 years, 20 years and 30 years. We then compared the taxes and savings for two scenarios: One where all the savings was after tax and one where all the savings was pre-tax. Here’s what we found assuming an 8% growth rate:

Dixon 6
This certainly dispels the myth that remaining in the same tax bracket is a wash, albeit in an ironic fashion. In all three time periods, the employee would pay more taxes using the tax-deferred vehicle, yet, the employee also ends up with more money. We changed the growth rate and found this relationship remained the same all the way down to a 0% growth rate. Only in this special case of no growth is there no difference between saving after tax and saving in a tax-deferred account. The likelihood of assets not growing over these extended time periods is virtually non-existent. The worst ten-year period still produced (slightly) positive growth.” (Carosa, CTFA). Carosa’s test clearly shows the tax benefit of 401(k) contributions. Saving any amount of money towards retirement is good. However, when possible every effort should be made to contribute the maximum amount allowed amount into the employer retirement plan. Saving now significantly increases retirement savings. When contributing the maximum to a 401 (k) plan qualifies your contributions to the maximum employer matching benefit. This is essentially free money. Retirement income of all kinds gets a pass in seven states. Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming have no state income tax. Most states offer some type of retirement-income exclusion, though some are more generous than others. Mississippi, for instance, exempts all retirement income, including public and private pensions and distributions from retirement accounts, such as IRAs and 401(k) s.