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Taking Retirement Plans

Taking advantage of employer-sponsored retirement plans

Employer-sponsored qualified retirement plans such as 401(k) s are some of the most powerful retirement savings tools available. If your employer offers such a plan and you're not participating in it, you should be. Once you're participating in a plan, try to take full advantage of it.

UNDERSTAND YOUR EMPLOYER-SPONSORED PLAN

Before you can take advantage of your employer's plan, you need to understand how these plans work. Read everything you can about the plan and talk to your employer's benefit officer. You can also talk to a financial planner, a tax advisor, and other professionals. Recognize the key features that many employer-sponsored plans share:

• Your employer automatically deducts your contributions from your paycheck. You may never even miss the money--out of sight, out of mind.

• You decide what portion of your salary to contribute, up to the legal limit. And you can usually change your contribution amount on certain dates during the year.
  
• With 401(k), 403(b), 457(b), SARSEPs, and SIMPLE plans, you contribute to the plan on a pretax basis. Your contributions come off the top of your salary before your employer withholds income taxes.
  
• Your 401(k), 403(b), or 457(b) plan may let you make after-tax Roth contributions--there's no up-front tax benefit but qualified distributions are entirely tax free.
  
• Your employer may match all or part of your contribution up to a certain level. You typically become vested in these employer dollars through years of service with the company.
  
• Your funds grow tax deferred in the plan. You don't pay taxes on investment earnings until you withdraw your money from the plan.
  
• You'll pay income taxes and possibly an early withdrawal penalty if you withdraw your money from the plan.

• You'll pay income taxes and possibly an early withdrawal penalty if you withdraw your money from the plan.
  
• You may be able to borrow a portion of your vested balance (up to $50,000) at a reasonable interest rate.
  
• Your creditors cannot reach your plan funds to satisfy your debts.
  

CONTRIBUTE AS MUCH AS POSSIBLE

The more you can save for retirement, the better your chances of retiring comfortably. If you can, max out your contribution up to the legal limit. If you need to free up money to do that, try to cut certain expenses.

Why put your retirement dollars in your employer's plan instead of somewhere else? One reason is that your pretax contributions to your employer's plan lower your taxable income for the year. 

This means you save money in taxes when you contribute to the plan--a big advantage if you're in a high tax bracket. For example, if you earn $100,000 a year and contribute $10,000 to a 401(k) plan, you'll pay income taxes on $90,000 instead of $100,000. (Roth contributions don't lower your current taxable income but qualified distributions of your contributions and earnings--that is, distributions made after you satisfy a five-year holding period and reach age 59½, become disabled, or die--are tax free.)

Another reason is the power of tax-deferred growth. Your investment earnings compound year after year and aren't taxable as long as they remain in the plan. Over the long term, this gives you the opportunity to build an impressive sum in your employer's plan. You should end up with a much larger balance than somebody who invests the same amount in taxable investments at the same rate of return.

For example, you participate in your employer's tax-deferred plan (Account A). You also have a taxable investment account (Account B). Each account earns 8 percent per year. You're in the 28 percent tax bracket and contribute $10,000 to each account at the end of every year. You pay the yearly income taxes on Account B's earnings using funds from that same account. At the end of 30 years, Account A is worth $1,132,832, while Account B is worth only $757,970. That's a difference of over $370,000. (Note: This example is for illustrative purposes only and does not represent a specific investment.)

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