More than half of all workers are covered by an employer-sponsored, defined-contribution retirement plan, also called a tax-sheltered retirement plan. These include 401(k) plans and similar 403(b) and 457 plans. Employer-sponsored retirement plans provide four distinct advantages
First Advantage: Tax-Deductible Contributions Tax-sheltered retirement plans provide tremendous tax benefits compared with ordinary savings and investment plans. Because pretax contributions to qualified plans reduce income, the current year’s tax liability is lowered. The money saved in taxes can then be used to partially fund a larger contribution, which creates even greater returns. The 401(k) plan lets the IRS help employees finance their retirement plans because of the income taxes saved.
As Table 1.2 illustrates, you can save substantial sums for retirement with minimal effects on your monthly take-home pay. For example, a single person with a monthly taxable income of $4000 in the 25 percent marginal tax bracket who forgoes consumption and instead places $500 into a tax-sheltered retirement plan every month reduces monthly take-home pay from $3175 to $2800, or $375—that is certainly not an enormous amount. The net effect is that it costs that person only $375 to put away that $500 per month into a retirement plan. The
immediate “return on investment” equals a fantastic 25 percent ($125 ÷ $500). In essence, the taxpayer puts $375 into his or her retirement plan and the government contributes $125. (Without the plan, the taxpayer would pay the $125 directly to the government.) A taxpayer paying a higher marginal tax rate realizes even greater gains. Because a substantial part of your contributions to a tax-sheltered retirement plan comes from money that you would have paid in income taxes, it costs you less to save more
Second Advantage: Employer’s Matching Contributions To encourage saving for retirement, many employers “match” all or part of their employees’ contributions, perhaps up to 6 percent of salary. An employee who saves $375 might receive an additional $375 a month from his/her employer. That’s a 100 percent return on the employee’s $375!
Third Advantage: Tax-Deferred Growth Because
interest, dividends, and capital gains from qualified plans are taxed only after funds are withdrawn from the plan, investments in tax-sheltered retirement plans grow tax free. The benefits of tax deferral can be substantial. For example, if a person in the 25 percent tax bracket invests $2000 at the beginning of every year for 30 years and the investment earns an 8 percent taxable return compounded annually, the fund will grow to $167,603 at the end of the 30-year period. If the same $2000 invested annually was instead compounded at 8 percent within a tax-sheltered program, it would grow to $244,691! The higher amount results from compounding at the full 8 percent and not paying any income taxes. (Figure 1.3 on page 13 illustrates thes differences in returns.) Indeed, when the funds are finally taxed upon their withdrawal some years later, the taxpayer may be in a lower marginal tax bracket
Fourth Advantage: Starting Early Really Pays Off Big Recall the rule of 72, which can be used to calculate the number of years it would take for a lump-sum investment to double. A 9 percent rate of return doubles an investment every eight years. Waiting eight years to begin saving results in the loss of one doubling. Unfortunately, it is the last doubling that is lost, as illustrated in Table 1.3. In that example, $48,000 ($96,000 $48,000) is lost due to a hesitancy to invest $3000. This is a tremendous opportunity cost for waiting eight years to start. The gains are awesome when the one starts early and makes regular, continuing investments instead of delaying. For example, a worker who starts saving $25 per week in a qualified retirement plan at age 23 will have about $616,390 by age 65, assumin
Second Advantage: Employer’s Matching Contributions To encourage saving for retirement, many employers “match” all or part of their employees’ contributions, perhaps up to 6 percent of salary. An employee who saves $375 might receive an additional $375 a month from his/her employer. That’s a 100 percent return on the employee’s $375!
Third Advantage: Tax-Deferred Growth Because
interest, dividends, and capital gains from qualified plans are taxed only after funds are withdrawn from the plan, investments in tax-sheltered retirement plans grow tax free. The benefits of tax deferral can be substantial. For example, if a person in the 25 percent tax bracket invests $2000 at the beginning of every year for 30 years and the investment earns an 8 percent taxable return compounded annually, the fund will grow to $167,603 at the end of the 30-year period. If the same $2000 invested annually was instead compounded at 8 percent within a tax-sheltered program, it would grow to $244,691! The higher amount results from compounding at the full 8 percent and not paying any income taxes. (Figure 1.3 on page 13 illustrates thes differences in returns.) Indeed, when the funds are finally taxed upon their withdrawal some years later, the taxpayer may be in a lower marginal tax bracket
Fourth Advantage: Starting Early Really Pays Off Big Recall the rule of 72, which can be used to calculate the number of years it would take for a lump-sum investment to double. A 9 percent rate of return doubles an investment every eight years. Waiting eight years to begin saving results in the loss of one doubling. Unfortunately, it is the last doubling that is lost, as illustrated in Table 1.3. In that example, $48,000 ($96,000 $48,000) is lost due to a hesitancy to invest $3000. This is a tremendous opportunity cost for waiting eight years to start. The gains are awesome when the one starts early and makes regular, continuing investments instead of delaying. For example, a worker who starts saving $25 per week in a qualified retirement plan at age 23 will have about $616,390 by age 65, assumin
an annual rate of return of 9 percent. Waiting until age 33 to start saving, instead of beginning at age 23, results in a retirement fund of only about $242,230. The benefit of starting to invest early is about $374,000 ($616,390 $242,230). And the total extra dollars invested over the ten years was a mere $13,000. Putting in $13,000 early results in an extra $374,000. This effect occurs because most of the power of compounding appears in the last years of growth.
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