401(K)/ Income Taxes
The 401 (k) retirement saving plan in essence defers a person’s current income on the money they save and their current income. Like Lu’s they are mostly employer-sponsored. To benefit the employee, the employer has an option to a fraction or all of the contribution that the employee has made by depositing some additional amount of funds into his account or giving him a profit sharing contribution plan (Donhardt, 2005)
From the year 2006, another type of plan, known as the Roth 401 (k) was developed where contributors to plans that have the prerequisite amendments can allocate some or all of their contributions to a separate account where they are collected and treated as after tax dollars (DoL, 2006).
The most common choice that most employees will have is the participant-directed plans where the employee can select from various investment choices though there is a choice to have the trustee-directed plans where the employer appoints people who decide how the funds are invested.
Whether the contributions are pre-tax or after-tax, their earnings are all tax-deferred. Therein is where the advantage of such a plan lies, especially when held over long periods of time. Taking for example the pre-tax plan, the employee would not have to pay federal income tax on the amount of her income that she defers to the plan.
Given that Lu earns $60,000, and she intends to invest up to 7% of her earnings, that is $4,200 (7% x $60,000). Her tax return for the year will be $55,800 ($60,000 – $4,200). Assuming no other deductions or any other adjustments; and given too that her marginal tax bracket is 15%; she would have up to $630 ($4,200 x 15%) savings in taxes every year. Similarly for 1% it would be $90, at 2%, $180, 3%, $270, 4%, $360, 5%, $450 and 6%, $540.
So when she will be withdrawing the money during her retirement, that is when she will pay the taxes. Any gains that she therefore acquires are treated as ordinary income when the money is withdrawn.
The other option would be the after-tax contribution. Any contributions to the Roth account in the Roth 401 (k) plan are the qualified distributions are tax free or can be made so depending on the amendments in the plan. In order to be eligible for such provisions, these distributions have to be made over a period of more than half a decade after the initial designate Roth contribution and before the year that the person who holds the account reaches the age of 59 and a half years old. Of course unless there is an exception that applies and is in tandem with the IRS code (Donhardt, 2005).
The difference with this plan from the previous one is that the amount of income that is taxable is not reduced and that they are irrevocable and as such, can never be converted to pre-tax contributions in the future. For better administration it is usually advisable that accounts for the Roth plan be separate and records pertaining to their management must be distinguishable from any other plans.
When it comes to retiring and retirement investment, which a person ultimately does if they are working, there are two basic parts that is the investment itself and the account that brings the best tax advantage. Apart from the 401(k) s; there is the 403 (b) s, IRAs, individual retirement accounts the Rollover IRA retirement plans and a plan for the self employed, the KEOGH.
Additionally, it would be best to spend IRA first. This delays the taking of Social Security until a person reaches the age of 70 and thus maximizes the inflation of adjusted income by the Government. Secondly, having the IRA withdrawals taxed under the current tax structure is better than if it were in the future because there is always a likelihood that taxes will rise and one may end up paying a higher rate as time goes by.
Default Investment Alternatives Under Participant Directed Individual Account Plans: Final Rule. Department of Labor. Retrieved from http://www.dol.gov/ebsa/regs/fedreg/final/07-5147.pdf.
Donhardt, T. (2005). Too many cashing out of 401(k). Indianapolis Business Journal.
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