Mechanics of 401(k)s (Pt. 1)

Many folks have a retirement plan, such as a 401(k), available from their employers. It is a relatively straightforward savings vehicle, but can still be very confusing if you don’t know what exactly is under the hood.

When you sign up for your company’s retirement plan, there are a few things you need to decide. Examine the mechanism carefully, because your livelihood in retirement depends on these decisions you make now.

Here are some questions you may encounter when you start a 401(k) plan:

How much do you contribute? You first decide the portion of your paycheck you put into your retirement account. You fill out a form (online, most of the time these days) to set aside a particular portion of your salary for the 401(k) plan.  Then, on each payday, you will see a deduction from your paycheck. 

The money you contribute is tax-deferred, meaning it reduces your taxable income. Because of this pre-tax nature of your deferrals, putting money in the 401(k) plan reduces your income taxes. For example, if your income is $30,000 a year in 2013, and you defer 5% of your income into the plan, your reported taxable wages are 5% less, or $28,500.  As a result, your possible tax bill goes from $2,553.75 to $2,328.75, a reduction of $225.

However, contributing to a 401(k) plan reduces only your income taxes, not other types of taxes. Social Security and Medicare taxes still apply to these deferrals.

The money in the plan is your money, just like your take-home pay.  When money is deferred to the plan, you have an increase in the balance, the same as your checking account increases with the direct deposit of your take-home pay. You can invest those funds as you see fit.

Pay your tax now or later? Depending on your company’s plan, you may have a Roth 401(k) plan available to you.  It is similar to the garden-variety traditional 401(k) – except that your contributions are post-tax, rather than pre-tax.  The money you contribute is taxed, so your tax bill remains the same with a Roth 401(k) plan. When you take the money out of the Roth 401(k) account at retirement, there is no tax on those withdrawals, and your investment growth is tax-free.

A Roth 401(k) plan is simply another component of the overall 401(k) plan.  You can choose to defer your salary to a traditional 401(k) plan or a Roth 401(k) plan, or both, as long as the combined contributions do not exceed the maximum amount in the tax year.

What is the maximum? Each year, the Internal Revenue Service set a cap on the annual contribution you can make to a 401(k) plan.  For 2014, it’s $17,500.

This annual limit applies to all retirement accounts you have. Even if you work at two jobs, and have a 401(k) with both, you can only contribute up to $17,500 in total to all plans for 2014.

There’s one exception. If you are over 50, you get an additional $5,500 catch-up contribution to the limit.

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Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.

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