Share this story
Close X
Switch to Desktop Site

'401(k)': a tax-deferred thrift plan with advantages over the IRA

One of the latest lures being used by companies to attract new employees is a plan to take away some of their pay. This particular lure is sometimes called a ''salary reduction plan,'' or a ''tax-deferred thrift plan.'' But it is more commonly known as a ''401(k),'' from the section of the Internal Revenue Code which describes how these plans are to work.

That name is becoming increasingly familiar to American companies and their employees. According to a survey of 424 companies earlier this year by Buck Consultants Inc., a New York benefits planning firm, nearly three-quarters of them either have adopted a 401(k) plan or expect to do so by the end of this year. Some 17 percent more were undecided, leaving only 9 percent that had decided against it altogether.

About these ads

At first glance, the 401(k) is very similar to an individual retirement account (IRA). It will let you set aside tax-deferred money from your paycheck to set up a retirement fund. And any interest the fund earns is tax-free until withdrawals begin.

After that, however, the similarities end and the 401(k) looks better. For example, up to 15 percent of income can be put in the 401(k), while IRAs have a limit of $2,000 per person, regardless of income. This makes the 401(k) particularly attractive to higher-income individuals.

In addition, many employers have programs in which they ''match'' the employees' contributions, up to a certain limit, say 6 percent of salary. So someone making $40,000 could put up to $6,000 into the 401(k) and an employer making a 6 percent match would kick in another $2,400. If this person could afford to set aside even more, he could still put another $2,000 a year into an IRA, making a total one-year retirement contribution of $10,400. Although this is probably more than most people at the $40,000 level could afford, it does indicate the difference in possibilities between a 401(k) and an IRA.

There are also advantages to a 401(k) at withdrawal time. With an IRA, any withdrawals made at retirement are taxed as ordinary income. But with a 401(k), if you take all the money out at retirement - or even a big chunk of it - you can use the more favorable 10-year forward averaging method to spread out the tax effects over a longer period.

These are some of the basics of 401(k). There are also some not-so-basics that have made these plans even more attractive. One of the nicest advantages being used of late is the ability to borrow from the 401(k), says Fred Rumack, director of tax and legal services at Buck. ''People can borrow from their plan without tax consequences,'' he said. ''And they can take the income-tax deduction on the interest they have to repay. Neither of these can be done with an IRA.''

In some cases, people have also been able to make untaxed early withdrawals from a 401(k), if they could prove they had a ''hardship'' that required the money. The Internal Revenue Service has not been much help in this matter, however: For more than a year, it has been promising a new set of regulations that would specifically define what a ''hardship'' is.

Until recently, it was assumed that the definition would permit money to be taken out to pay uninsured emergency medical expenses, to make the down payment on a new home, and to pay higher-education expenses.

About these ads

''But right now all we're dealing with is rumors,'' said Ira Kastrinsky, a principal with Kwasha Lipton, a Fort Lee, N.J., benefits consulting firm. ''But the latest rumor is that they (IRS officials) aren't going to allow the last two'' - a new home and education expenses. ''The thinking seems to be that these are foreseeable expenses and therefore aren't hardships. They really want this money to be used for retirement.''

Those final, definitive IRS regulations are expected sometime this year.

An interesting aspect to 401(k) plans, Mr. Rumack and Mr. Kastrinsky agree, is that much of the impetus for them seems to be coming from the employees. While retirement savings programs are usually designed by outside consulting firms and explained to workers by company personnel departments, the 401(k) is often suggested by employees who have read about them on their own. Unlike IRAs, which can be opened by anyone earning money, a 401(k) has to be established by an employer.

Comparing CDs

I would like to put some money in certificates of deposit at a bank. But the banks all seem to have different interest rates, making things very confusing. How can I compare them? - A. N.

For CDs of one year or less, look for ''annual effective yield.'' This number takes into account the various ways banks compound interest. Compounding can be done annually, semiannually, quarterly, monthly, weekly, daily, or continuously, meaning on an instant-to-instant basis.

If you are buying only a six-month CD, be aware that banks often quote a rate that assumes you will roll it into another CD at the end of the six months. As this is not always the case, ask for the ''real effective yield'' for the six-month period.

For certificates of more than a year, say 21/2 to 5 years, look for ''average annual yield.'' This shows the yield you can expect over the life of the investment, instead of just the first year, which is usually higher than the others.

If you would like a question considered for publication in this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.

Follow Stories Like This
Get the Monitor stories you care about delivered to your inbox.