Are you one of many who are "eligible nonparticipants" of their company's 401(k) plans? If that's you, what's your rationale? About 60 million Americans do participate in their 401(k)s, according to the Investment Company Institute's "Frequently Asked Questions About 401(k) Plan Research" (tinyurl.com/2p8btwkh).
I started a conversation with you on this topic a few weeks ago, urging you to get answers about your plan (let me know if you missed the columns). Let's continue with a few more questions to consider:
Q: If your employer contributes to your 401(k), will your W-2 income go up?
No, and that's a good thing. Employer contributions are pre-tax, which means they are not included in your W-2 as taxable income. For example, if your employer contributes $5,000 and your salary is $50,000, your W-2 will show income of only $50,000, not $55,000.
That's a clear benefit for you at tax time. It's like getting a bonus that is not taxed. Remember that all monies in your pre-tax 401(k) are not taxed until you start withdrawing funds -- hopefully, not until you retire. That's another big benefit of participating in your 401(k): no taxes dragging down performance during the time that you stay in the plan or roll over to another plan or tax-deferred IRA.
Taxes do enter the picture, however, when you withdraw funds. (We'll talk more about taxes in a subsequent column.)
Q: Do you have to do something to get an employer contribution, assuming your plan offers one?
First you need to be a participant. Second, if you have a plan with a match, you need to contribute. If you have that type of plan, study how the match works, including the vesting schedule. A common match is 50 cents on the dollar up to a cap of 6% of compensation, according to the Plan Sponsor Council of America. The next most common match is $1 per $1 up to 6% of compensation.
Vesting is about time on the job. Some contributions are "fully vested," which means your match is yours right away. Others vest over time according to a schedule.
Q: If you contribute to your 401(k) on a pre-tax basis, what is your "cost" per dollar after you figure pre-tax advantages? Assume a dollar-for-dollar match and a 10% effective tax rate.
Here is an example of how to think about this question:
Compare what you can do on your own with savings of $5,000 outside of your 401(k) plan. You have $5,000 from your paycheck. You put it in the bank or in the market, and it is taxed as it grows. Your "cost" of this investment is $5,000; so is the starting value.
Now, assume you take the same $5,000 and contribute it to your 401(k). But wait, it's not the same. Your contribution is pre-tax, not after-tax.
Since it's pre-tax, the dollar amount that you are putting to work in your 401(k) is $5,000. But, because of your tax savings, you can think of "buying" that $5,000 at a "discount." If your effective income tax rate is 10%, your discount is 10%, or $500.
What about that employer dollar-for-dollar match of $5,000, which is also pre-tax? That gives you $10,000 in your 401(k), but your "cost" is only $4,500 (your $5,000 less the pre-tax discount -- 10%, or $500).
The $10,000 does not increase your W-2 income. In fact, your W-2 is reduced by your pre-tax salary deferral of $5,000.
So, you "paid" $4,500 for a $10,000 401(k) -- that's a gain of $5,500 (a 122% return) before you even start to invest those funds.
You can't beat that on your own, with no discounts, no long-term tax advantages and no leverage from an employer contribution.
If you are a nonparticipant, find out more about your 401(k). Are you sure you are making the right decision or just avoiding homework? Or, is it something else? If you feel you can't afford to participate, give me details; I'll cover the subject in a future column.
Julie Jason, JD, LLM, a personal money manager (Jackson, Grant Investment Advisers Inc. of Stamford, Connecticut) and award-winning author, welcomes your questions/comments (readers@juliejason.com). Please visit www.juliejason.com.
DISTRIBUTED BY ANDREWS MCMEEL SYNDICATION