Q—401(k) Plan

These plans allow eligible employees to defer compensation or bonuses and contribute the funds to an employer-sponsored profit sharing plan. They are funded entirely or in part through salary reductions elected by the employees. Because employee participation in 401(k) plans is entirely voluntary, employers will often encourage participation by matching employee contributions. These matching contributions are typically limited to a maximum percentage and/or maximum dollar amount.

One of the better ways of explaining the advantages of participating in a 401(k) plan is to contrast current nonparticipation with the benefits of participation (i.e., a “before and after” presentation).

WITHOUT PARTICIPATION.Assume that in 2022 a 35-year-old married employee with an annual salary of $52,000 currently pays $2,979 in federal income taxes, $840 in state income taxes, and $3,978 in Social Security taxes. This leaves $44,203 of “take-home pay,” with nothing set aside for retirement. (Calculation assumes: joint filing, standard deduction, and 3 percent of federal AGI state income tax.)

WITH PARTICIPATION.Now assume that this same employee has the opportunity to participate in a plan with a 50 percent employer match, (i.e., the employer will contribute one dollar for every two dollars of employee elective deferral). If the employee elects to defer 6 percent of salary ($3,120 per year), the employer would then make a matching contribution of $1,560. The total annual deposits to the employee’s account are $4,680, consisting of the employee’s elective deferral of $3,120 and his employer’s matching contribution of $1,560. Because his contributions are before tax, the employee’s federal income taxes are reduced to $2,605 and his state income taxes are reduced to $746. Social Security taxes are not affected by employee elective deferrals. Take home pay will be reduced to $41,551.

Note that a reduction in take-home pay of only $2,652 has produced a deposit of $4,680 into the employee’s retirement account. The efficiency of this is even greater for taxpayers in a higher tax bracket (the top marginal federal rate is 37 percent in 2022) than this example where the taxpayer’s top marginal rate is (temporarily because of the 2017 Tax Act) only 12 percent.

A 35-year-old employee can accumulate $393,720 by age 65; assuming level plan contributions of $390 at the beginning of each month and 6 percent interest on plan assets. Over the same 30-year period, total employee contributions amount to only $93,600. Waiting just five years to begin participation would reduce age 65 projected accumulations to $271,619, which is $122,101 less than would accumulate assuming immediate participation (393,720 - 271,619 = 122,101).