The One-Two-Three's of 401(k)s and 403(b)s
Farm Management Update, April 1996
By Alex White, Dixie Watts Reaves, and David M. Kohl
Salary Reduction Plans, popularly known as 401(k) or 403(b), are powerful retirement tools that deserve considerable attention by= agricultural producers and small business owners. While these plans are offered by few farms and small businesses, a majority of larger businesses make them available to their employees. A recent survey, by J.R. Marker and Dr. David M. Kohl, Department of Agricultural and Applied Economics, Virginia Tech, shows that relatively few producers utilize the Salary Reduction Plans available through off-farm jobs that they or their spouses hold.
What is a Salary Reduction Plan?
There are several types of Salary Reduction Plans: 401(k), 403(b), 457, 501(c), and 503(c), to name a few. The major differences in plans lie in who can offer them. For example, 401(k) plans may be offered by most "for profit" businesses; while 403(b) plans may be offered only by public school systems; 457s may be offered by municipalities and government agencies; 501(c)s are for employees of non-profit organizations; and 503(c) plans are for members of professional organizations. The basic concept of a Salary Reduction Plan is for the employee to have a portion of his/her pre-tax income contributed to the retirement plan. These annual contributions are not subject to income taxes until they are withdrawn from the account; however, they are still subject to Social Security and Medicare taxes (FICA). As with IRAs and SEPs, the earnings of the 401(k) or 403(b) account are not subject to income taxes until they are withdrawn from the account. For 401(k) plans, any funds withdrawn from the account before age 59=BD are subject to a 10 percent penalty as well as ordinary income taxes. However, the funds from a 403(b) account may be withdrawn without penalty at any time, as specified by the written policy of the plan.
Who Can Establish?
Any employer can establish a Salary Reduction Plan. However, due to the administrative costs and responsibilities, these plans typically are not established for farms and small businesses.
As with IRAs and SEPs, there are limits to the amount of the annual contribution to a 401(k) or 403(b) plan. The employee's contribution to a 401(k) is limited to the lesser of 15 percent of compensation, or $9,240 (as of 1994). The employer may supplement this amount with matching contributions; however, the maximum of employee and employer contributions cannot exceed the lesser of 25 percent of the employee's compensation or $22,500. For example, Jack earns $48,000 per year working for a consulting firm. If Jack enrolls in the company's 401(k) plan, he can contribute up to $7,200 per year (15 percent of $48,000) in his account. 403(b) plans currently have slightly different limitations.
The maximum annual employee contribution to a 403(b) plan is the lesser of 20 percent of includable compensation (16.67 percent of gross compensation) or $9,500. With matching employer contributions the combined annual contributions cannot exceed 25 percent of taxable compensation or $30,000. Further, most 403(b) plans contain a "catch-up" provision which allows employees with at least 15 years of service to contribute more than the stated annual limit to compensate for years when less than the maximum contributions are made. The dollar amount of the contribution limit may change over time, as it is indexed to the rate of inflation. The company's benefit officer is the best source for the complete details about the Salary Reduction Plan offered by the company.
Salary Reduction Plans may be combined with other retirement tools, such as IRAs and SEPs. The total annual contribution to all retirement plans cannot exceed the lesser of 25 percent of compensation or $30,000.
Can I Borrow From These Plans?
Funds may be borrowed from a 401(k) plan, but typically not from the other Salary Reduction Plans (403(b), 457, etc.). Approximately 75 percent of U.S. companies allow their employees to borrow from their 401(k) plans for any reason, not just for emergencies. The IRS allows an employee to borrow one-half of the total of the 401(k) account, up to a maximum of $50,000. A loan from your 401(k) to buy a house must be repaid within either 15 or 30 years. All other loans must be repaid within 5 years. An advantage to borrowing from the 401(k) is that all interest charges go to the account balance rather than to an administrative agency.
Advantages of Salary Reduction Plans
The advantages of a Salary Reduction Plan are similar to the advantages of IRAs and SEPs. Annual contributions reduce taxable income for the year in which they are made. These contributions and earnings of the plan are not taxed until they are withdrawn from the account. For example, Jack is in the 28 percent Federal marginal tax bracket. If Jack makes an annual contribution of $7,200 to his 401(k), he will reduce his annual income tax liability by $2,016 ($7,200 x 0.28). Finally, because the annual contribution limit is higher than for IRAs, and because these plans typically allow matching contributions from the employer, Salary Reduction Plans enable an individual to invest more funds into tax- advantaged instruments than IRAs.
Disadvantages of Salary Reduction Plans
Again, the disadvantages of these plans are similar to those of IRAs and SEPs. The funds invested in Salary Reduction Plans are typically not liquid, requiring waiting until age 59=BD to remove funds from a 401(k) without penalty. Further, as the name implies, "Salary Reduction Plan" means having less "take home" pay. The monthly paycheck will be reduced because a portion of the salary is being contributed to the plan.=20 However, it is not reduced by the total amount of the contributions, because every dollar of contribution reduces the income tax liability. For example, Jack's gross monthly salary is $4,000. Without 401(k) contributions, Jack receives a monthly paycheck of $2,880 after Federal taxes are withheld. By contributing 15 percent of his salary ($600/month) to the 401(k), Jack will receive a monthly paycheck, after Federal income taxes, of $2,448 ([$4,000 - $600] x (1 - 0.28). Thus, Jack's monthly paycheck only decreases by $432 instead of the full $600 contributed to the 401(k).
Salary Reduction Plans provide another avenue for agricultural producers and small business owners to provide for their retirement. While these plans typically are not established by farms or small businesses, they are a powerful source of retirement income for those with off-farm/non- business jobs. Although participants in a 401(k) or a 403(b) plan have less "spending money" after the contributions are made, they have the satisfaction of knowing they are taking valuable steps toward providing for their retirement, as well as making good use of the tax advantages of these programs.
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