M E R I D I A N     M A G A Z I N E

THE 401(k) The Nation's Biggest Tax Shelter for Ordinary People (and it was an accident)
by Richard P. Halverson

Each year billions of dollars are diverted by individuals from government coffers and into private investment accounts of ordinary taxpayers. The question is are you doing your fair share of the diverting?

Just about everyone has heard of 401k's, the popular way to save money through payroll deduction. Today more than 25 million Americans are investing more than a trillion dollars through 401k accounts. If Americans were ever prone to stop and thank their elected representatives for coming up with and implementing a wonderful idea, this would be the one.

This enlightened program allows workers to invest their own money for their own future before turning it over to the government to do it for them. The novel concept seems to be that ordinary people know how to take care of their own money at least as well as Washington. For giving us this great gift, you would think voters would be looking for those members of Ccongress who fought for and succeeded in passing the 401k legislation so they could thank them. Funny thing is, these grateful Americans will never find those visionary and brave politicians. The legislation was an accident. It was never intended to become one of the most popular and valuable employ benefits in history.

Finding the Hidden 401K
The story is that in 1980 a benefits consultant by the name of Ted Benna accidentally discovered the 401(k) paragraph - for which the program is now named - buried in an obscure change in the 1978 tax law. The change was simply intended to resolve some issues related to a specific bank's profit sharing plan.

A gutsy test case engineered by Mr. Benna produced a surprisingly favorable ruling from the IRS, and 401k's were born. Politicians did not see this as an opportunity for you to have more control over your own destiny and risk their careers fighting on your behalf for it. In fact, perhaps more typical of politicians, by the mid-1980's many of them were very unhappy with the program. From their view, the government was losing more and more of its revenue to the popular plan. (I hate to be political here but many politicians really believe tax dollars are their money not yours.)

In 1985 there was an effort to eliminate the 401k law. By that time, however, 401k's were sufficiently popular that Congress was forced to back down or face voter wrath and the paragraph survived - mostly. They did succeed in lowering the maximum amount you can contribute from $30,000 a year to a current limit of $10,000.

Even with the lower limit the 401k program is one of the government's biggest tax breaks for individuals. According to the Congressional Joint Committee on Taxation, the tax break costs the federal government more in tax revenue than any other tax deduction, including the mortgage deduction. See why politicians are upset? Each year billions of dollars are diverted by individuals from government coffers and into private investment accounts of ordinary taxpayers. The question is are you doing your fair share of the diverting?

Why the 401K Is So Valuable
If you have a 401k available where you work you should be taking maximum advantage of it - period! No other investment program I am aware of is as advantageous to investors as the 401k.

Here are the features that make 401k's so valuable:

• Dollars you contribute are not taxed. In fact, they do not even show up on the W-2. If your salary is $30,000 a year and you contribute $2,000 to a 401k your taxable income will be reported as $28,000. Lower reported income means lower taxes, of course. The money will be taxed when its withdrawn but this is still a great tax shelter for ordinary people.
• Earnings on your investments accumulate without being taxed until you withdraw them. This is another significant tax shelter.
• 401k's are offered by employers. Plans vary from company to company but in general there are considerable advantages in having the company administer the program.
• Companies provide payroll deduction. This makes contributing easy and automatic.
• Companies frequently match a portion of the contribution the employee makes. This is a huge benefit. The most common match is 50%. As an encouragement for you to save, the company will give you $0.50 for every $1.00 you save.
• Companies provide administration, record keeping and communication of the program. Most absorb these costs. They also encourage employees to participate and will provide education and information to make it easy.
• 401k dollars can be invested in a wide variety of investments ranging from almost all kinds of mutual funds to individual stocks and bonds.
• Companies usually offer only a handful of investment selections. However, for the vast majority of 401k participants this is an advantage. The company uses experts to select a handful of professionally run investment alternatives such as mutual funds. This never guarantees these will turn out to be the highest earners in the future but it improves the odds. For most people this professional help supplied by the company means they can avoid the daunting task of sorting through all the possible investment options in the world.
• 401k's are portable. If you change jobs you get to keep the money. (Company matching funds are frequently subject to certain vesting requirements. If you leave before you are vested you may not get to keep all the matched funds.)
• Under certain circumstances you may be able to get at your 401k dollars before you retire. Many plans allow you to borrow from your 401k and pay it back plus interest. You can even withdraw your funds prematurely. However, this is almost always a terrible idea. (More on this later.)
• Participation is voluntary. If you do not want to save for retirement you aren't required to.

Illustrating the Advantages
If there are any significant disadvantages to a 401k plan, they are in these last two points i.e. participation is voluntary and there are ways to withdraw the money early. A principle concern among employee benefit specialists is that participation in plans is well below 100%, especially among lower salaried employees. And among those employees that do participate not all save as much as possible. In my next column, I will expand on the various problems that exist with 401k's. However, I want to provide some numbers that illustrate the great advantage in investing retirement funds in a 401k.

Here are the basic assumptions.

• Age 35
• Income $35,000
• Estimated inflation rate 3.5%
• Estimated salary increases 5.0% (An individual's income usually does rise faster than inflation over time through promotions and seniority.)
• Maximum employee contribution 6% of income.
• Employer match 50%
• Estimated retirement age 65
• Estimated investment earnings 9%
• Tax bracket 25%
  

Very quickly in the first year we see the genius and benefit of the 401k plan. Two important entities help you save. First, the employer in this case put in a $1,050 match. Second, in a sense the government put in a $543 match ($525 + $18) in the form of taxes they agreed not to collect. $1,593 dollars in matches from these generous sources plus the earnings on the matches means the 401k account is worth $3,292 at the end of the first year versus $1,628 for the regular account.

Watching it Grow
Of course, this is just the first year. Here is where that wonderful concept of compound earnings gets leverage. When this employee turns 65, the 401k will be worth $736,178 while the regular investment account will be worth only $258,126. The tax person's generosity extends only so far, however. It ends when the 401k funds are withdrawn. Then the government will tax every dollar. I guess that is fair, every dollar went in without being taxed. No taxes are owed on the regular investment account since those taxes have been paid each year. But even with taxes at the end, the 401k will beat the regular account by a wide wide margin. This is because of all the years that all that extra money was growing in the account. The alternative would have been for the government to have the money all those years and it doesn't usually grow when the government has it - especially not for you.

For our purpose here I assume the same tax rate after retirement. Chances are our retiree will be in a lower tax bracket during retirement. If not it either means the government has raised taxes or the retiree made so much money in her 401k he is now in a higher tax bracket. We'll hope for the latter.

Two Scenarios
The following table is designed to convince you - if you are not already convinced - that taking full advantage of a 401k account is smart thing to do. The first scenario uses the assumptions listed five paragraphs above. The columns show how much will be accumulated in the 401k account at retirement before taxes. The second column gives the effective value after the taxes that will be paid as the money is withdrawn during retirement. The third column is the accumulated value of the same pre-tax dollars invested in a regular taxable investment account.

In scenario #1 the after tax value of the 401k is more than 113% greater than the regular investment account. The subsequent scenarios test changes in the basic assumptions. The amounts change but the story is always the same i.e. the 401k account is far more valuable than a regular taxable account. Compare each scenario to the first to see the effect of the changed assumption. The value of starting early, contributing as much as possible and earning a good return is evident.

Probably none of these scenarios fits your circumstance but the message is clear - the governments accidental 401k tax shelter is so valuable you need to be taking full advantage of it.

There are some problems with 401k's in the country today. Really there are. These problems have the same politicians who never could have thought up 401k's to begin with and probably wouldn't have passed what they couldn't think up if they had, worried. Real worried. Don't be surprised to see them try to fix it. In the next installment I will detail these problems so you can see if you think it is or isn't broken and in need of urgent political fixing.

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