401(k) Plans
What is a 401(k) Plan?
Well, let's face it. Not everyone is going to be self-employed, so there has to be retirement plans of
the working man (or woman). A 401(k) is just that. A 401(k) plan is a fancy term for a salary
reduction plan. These types of plans work in two basic ways:
- Your employer contributes an amount for your benefit to a trust account. You would not be
taxed on your employer's contribution.
- You agree to take a salary cut or to pass up a salary increase. The amount equal to the pay
reduction is put into a trust account for your benefit. This is considered to be like your
employer's contribution.
The income that you earn in these trust accounts accumulate tax-free until it is withdrawn. Like the
other two retirement accounts that we have outlined (IRAs and Keoghs),
withdrawals before age 59 1/2 are limited. Premature withdrawals are also subject to a 10% penalty.
Is It Wise to Take a Salary Reduction?
Taking a pay cut is a great way to defer income and build up a tax-free base of money. Taking such
a cut does not reduce future Social Security benefits, either. Administering a salary reduction is
easy to do, also. The contributions are automatic and the company's trustees do all of the work.
Taking a salary reduction makes sense. The less you have to show, the less you can be taxed upon.
The maximum salary reduction is not a fixed dollar amount, but a percentage of your income.
However, there is a limit on the maximum tax-free salary-reduction deferral that you can take. In
1989, the ceiling was $7,627, but this was increased the following year by an inflationary factor.
Salary reductions in excess of this are treated as taxable income. Your employer, however, is free to
make additional contributions to your 401(k), as long as it does not exceed the lower of 25% of your
income or $30,000.
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