Salary Deferral Contributions Made to 401(k) Retirement Account

Most employees would agree that contributing towards their 401(k) retirement plan and building up a nest egg for the future is vital to their success in the future. Despite of knowing this, a significant number of corporate employees in America do not have 401(k) or other retirement plans. The reason for this is that these employees do not recognize the important of having and maintaining a 401k retirement plan or have lack knowledge of 401k contribution rules and limits. In this article, we discuss some of the examples of making salary deferral contributions to an employer sponsored 401(k) plan.

Salary deferral contributions made to an employer sponsored 401(k) plan are made on a tax-deferred basis meaning your taxable income for the year is reduced by the amount of contributions you make to the plan. As an example, consider John who makes $45,000 in 2008 and is in the 25% tax bracket. There can be two taxation scenarios, one where John contributes to a 401(k) plan and the other where John does not. Let’s look at each one separately:

a) John contributes 5% of his annual salary to his employer sponsored 401(k) plan:

As you can see, by contributing 5% of his annual salary to a 401(k) retirement account, John lowers his tax payable from $11,250 to $10,687.50 – total savings of $562.50! Of course your individual tax savings depend on your total compensation, the tax bracket you are in and what percent of your salary you contribute to a 401(k) plan.

ii) Tax Deferral of any Investment Gains on Contributions

Another benefit of making contributions to a qualified 401(k) plan is that any gains or earnings you make on your invested funds also grow on a tax-deferred basis until withdrawn, upon which they will be taxed at your local income tax rate at that time. Thus, if you expect that when you retire at age 65 and you will in a lower income tax bracket than what you are in now, it makes sense to grow your money tax-deferred and withdraw it at a time when you will be in a lower tax bracket than the one you are in now. Let’s consider an example:

Peter earns $45,000 for the year 2009 and wants to contribute $5000 from this towards his 401(k) plan. Peter is deciding whether he should invest $5000 towards a certificate of deposit with post-tax funds, or make pre-tax salary deferral contributions to his employer sponsored 401(k) plan.

Note: To keep things simple, let’s assume a 7% rate of return on both investment options.

As you can see, if Peter invests in a certificate of deposit, he will have $6943.94 at the end of the 5th year, assuming his earnings got taxed at 15%.

ii) Deposit the $5000 to a tax-deferred 401(k) account

Year	Invested Principal	Interest Amount (7%)	Net Ending Amount (Pre-Tax)	Tax Deducted on Interest Earned	Net Ending Amount (After-Tax)
1	$5,000.00	$350.00	$5,350.00	$0.00	$5,350.00
2	$5,350.00	$374.50	$5,724.50	$0.00	$5,724.50
3	$5,724.50	$400.72	$6,125.22	$0.00	$6,125.22
4	$6,125.22	$428.77	$6,553.98	$0.00	$6,553.98
5	$6,553.98	$458.78	$7,012.76	$0.00	$7,012.76

If instead however Peter invests in a tax-deferred 401(k) account, he will have $7012.67 at the end of the 5th year, which is $68.62 higher than the first option because his option is on a tax-deferred basis. Again, we are assuming a 15% tax bracket.

iii) Receipt of Employer Matched Contributions – A source of Free Money

Say John’s employer will match his 401(k) contributions by $0.50 for every $1 of contributions he makes, up to 6% of his salary. Let’s note that 6% of Peter’s salary is:

Maximum employer match = 6% x $45,000 = $2,700

This specifies that John is eligible to receive a maximum of $2,700 from his employer in employer matched contributions.

However, John only contributes $5000 to his employer sponsored 401k. Here are the calculations:

John’s Contribution = $5,000

Employer match rule = $0.50 / $1 = 50%

Final employer match = 50% x $5,000

Final employer match = $2,500

Notice that this $2,500 match from John’s employer is under the maximum threshold of $2,700. Think of this $2,500 as an instant 50% investment gain you have made, not bad at all right? This is the advantage of contributing to an employer sponsored 401(k) plan. If John had instead invested his money in a certificate of deposit, he would NOT have received this $2,500 additional match.

ii) Deposit the $5000 to a tax-deferred 401(k) account

Year	Invested Principal	Interest Amount (7%)	Net Ending Amount (Pre-Tax)	Tax Deducted on Interest Earned	Net Ending Amount (After-Tax)
1	$5,000.00	$350.00	$5,350.00	$0	$5,350.00
2	$5,350.00	$374.50	$5,724.50	$0	$5,724.50
3	$5,724.50	$400.72	$6,125.22	$0	$6,125.22
4	$6,125.22	$428.77	$6,553.98	$0	$6,553.98
5	$6,553.98	$458.78	$7,012.76	$0	$7,012.76
				Employer Match	$2,500
				Total in 5 years	$9,512.76

Thus at the end of 5 years, John will have $9,512.76 in his 401(k) account thanks to his employer matched 401k(k) contributions, as well as salary-deferred contributions. This is $2568.82 higher than if he invested solely in a certificate of deposit.