By William H. Black Jr.
There’s a time in a self-storage operator’s life when the question arises, “How do I keep more of the money I make?” Frequently, the answer is “with a qualified plan.” Called “qualified” because the contributions qualify for an income-tax deduction, these plans offer many significant benefits.
While there are many types of qualified plans available, this article focuses on the most popular, the 401(k) plan. Of course, implementation is strictly your decision; but before you make it, let’s discuss the basics.
What Is a 401(k) Plan?
In essence, a 401(k) is a tax-deductible savings account. Its name is taken from the Internal Revenue Code. These plans first became popular in the 1980s and are rapidly becoming an alternative to the more traditional retirement pension previously sponsored by employers, otherwise known as defined-benefit plans. However, the 401(k) structure does place the bulk of the responsibility of saving and investing on the employee himself. Additionally, employer contributions can vary drastically in amount and frequency.
Saving with a 401(k) retirement plan helps reduce taxable income, as all contributions by the employee and employer are deductible. And under the Employee Retirement Income Security Act of 1974, pension monies are judgment-creditor proof!
These plans generally offer various options as to how and where contributions are invested. Typical investment options are mutual funds, money-market investments, Target Date Funds, Asset Allocation funds or a combination thereof. Most plans offer the employee flexibility in how to allocate his account balance among the offered investment options. A good platform offers each participant his own private Web page to access his account and make trades.
What Is a Matching Contribution?
A matching contribution is an extra contribution to your account, paid for by the company, with tax-deductible dollars. Many plan designs will match whatever contribution you make, up to a certain percentage.
For instance, let's say in your design the match is 100 percent of your contribution up to 3 percent of your W-2 income. Assume you make $50,000 a year and you contribute 3 percent, or $1,500. Your company will match that at 100 percent, putting another $1,500 in your account. So in this particular year, investment gains aside, your 401(k) savings would go from $1,500 to $3,000—an exceptional increase in your account by any measure!
What Is Vesting?
Simply put, vesting is “earning” the employer’s contributions. 401(k) plans are not bonus plans. They are not severance-pay plans. They are rewards for long and loyal service. Employees who leave early abandon all or part of the employer’s contribution. For example, let's say your company requires six years of employment before being fully vested. If an employee leaves before that time, he won't be able to keep all the money his company contributed.
Of course, all the money employees contribute and any Safe Harbor employer contributions vest 100 percent immediately. A Safe Harbor 401(k) is similar to a traditional 401(k) plan, but the employer is required to make contributions for each employee. One other point: Vesting accelerates to 100 percent on a participant’s death, reaching retirement age or plan termination. That’s the exception.
If an employee leaves employment after, say, two years, he’ll likely keep only 20 percent of the company's contributions. The other 80 percent is forfeited, stays in the plan and is allocated, or spread, among the remaining participants.
What Happens When an Employee Leaves?
If an employee leaves or is terminated, any monies he deferred from salary, any Safe Harbor contributions and any vested employer contributions are payable to the employee. All other monies are forfeited. How does a former participant receive his vested account? He can roll it over income-tax-free to his IRA account, roll it tax-free to another employer-sponsored plan (if allowed by the plan document), or take the money, pay tax on it, and do whatever he chooses.
How Are Income Taxes Paid?
You don't have to pay tax on the money you contribute from your salary or any funds your company adds in the year contributed. You also don’t pay taxes on the earnings in your account or the forfeitures allocated to your account. In other words, as long as the money remains in the account, it grows without current taxation and is protected from the claim of judgment creditors. For example, if your income is $150,000 this year and you put $17,500 into your 401(k) account during the year, your taxable income next April 15 will be $132,500 ($150,000 minus $17,500), not $150,000.
Of course, the time will come when income tax is due. When is that? Taxes are due at ordinary income-tax rates when the monies are withdrawn from your account. Generally, one’s account balance is rolled income-tax-free to one’s IRA account where it continues to grow on a tax-deferred, asset-protected basis until withdrawn at age 70 and half under the Required Minimum Distribution rules.
Is There a Limit to How Much One Can Contribute?
There’s a limit to how much an employee can contribute to his 401(k) plan. For 2014, the limit for one’s salary deferral is 100 percent of earned income (W-2 or net Schedule C) up to $17,500. If the employee is 50 or older, there’s an additional $5,500 “catch-up” contribution allowance, bringing the total salary deferral to $23,000.
However, your company’s contributions are over and about those limits. The combined salary deferral and employer contribution limit for 2014 is $52,000. For age 50 or over, the total becomes $57,500 ($52,000 plus $5,500 catchup). Remember, these contributions are tax-deductible, so the IRS limits the amounts.
Should You Start Now?
It’s called the “time value of money,” meaning the sooner you start, the more money you'll have in the future. That’s the magic of compound growth! Think about it: You get a return on your salary deferral, the company’s contribution, allocated forfeitures, etc. And don’t forget the income-tax deduction. What’s not to like?
Assume you live in a state where the income-tax rate is 6 percent. Add to that a federal income-tax rate of 25 percent, and your total tax bite is 31 percent. Assume you defer $17,500 from your W-2, and your company puts in enough employer contributions to bring your total contribution to the maximum of $52,000. How does this compare to just paying the taxes?
As the chart demonstrates, the 401(k) saved $16,120 in taxes in the first year, assuming the 25 percent federal tax bracket and the 6 percent state. Are you in the 39.6 percent federal bracket and 6 percent state? Your total tax bite is 45.6 percent (39.6 percent plus 6 percent). Now the total tax savings becomes $23,700 ($52,000 times 45.6 percent). Add to that the tax-deferred growth, the asset-protection features and the compounding of the account’s value, and this becomes a significant part of your overall financial plan.
It’s never too late to establish a 401(k) plan, particularly if your employer offers a contribution program. These plans can reduce your tax burden and help you save for your retirement.
Note: This discussion is not intended as tax advice. The determination of how the tax laws affect a taxpayer is dependent on the taxpayer’s particular situation. A taxpayer may be affected by exceptions to the general rules and other laws not discussed here. Taxpayers are encouraged to seek help from a competent tax professional for advice about the proper application of the laws to his situation.
William H. Black Jr. has been in the pension-administration business for 34 years. His firm, Pension Services Inc., administers defined contribution and benefit plans and employs an ERISA attorney, an enrolled actuary and a complete clerical staff. He is a speaker and author for several industry journals and has appeared on financial radio shows to discuss retirement and financial matters. To reach him, call 888.412.4120; e-mail [email protected]; visit www.pensionsite.org.