We find our disciplined friend looking a little bit confused. After greeting us, he says: my son has just graduated and got his first job, they are offering him a retirement savings plan, but he is very young and I don’t know if it is a good idea, what do you think?
Retirement savings plans[1], particularly those offered within an employment relationship, are governed and protected by federal laws, particularly the EmployeeRetirement Income Security Actof 1974 (ERISA), and by its changes up to the Secure 2.0 Act of 2022. One of the most important benefits and differentiators of these plans is their tax treatment. The employer may deduct contributions as an operating expense, and the employee benefiting from the employer’s contributions and making his or her own contributions may deduct the full amount contributed on his or her personal tax return[2].
Apart from the immediate savings in taxes, the law gives these saving vehicles the benefit of not being subject to taxes while the funds remain in the plan. This has a direct impact on the growth potential of the contributions. By not having to pay taxes on distributions or capital gains, the entire amount can be reinvested year after year, increasing the effects of compound returns[3].
Because retirement savings plans tend to have longer terms, any chance of getting contributions to grow more will result in higher end amounts and a greater ability to cover expenses in retirement.
Another of the advantages of this type of plan is the practice, quite common, in which the employer offers to make additional contributions as an incentive and if the employee is already contributing. This practice increases the employees’ annual contribution amounts.
In view of the above, a young person who makes recurring contributions will benefit from the impact of no taxes now and for many years to come, the employer’s contributions, and the multiplier effect of compounding returns on capital.
On the other hand, the law requires these plans to be eventually distributed collecting taxes as if they were current income. For this reason, these plans are called tax-deferred: taxes are not paid upfront or during the accumulation phase, but they are paid during the distribution phase. In this sense, the law requires that, starting at a certain age, minimum distributions be made.
In conclusion, young people[4] would do themselves a great favor by starting to contribute to their employment-based retirement savings plans on a recurring basis and as soon as possible.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your situation.
[1] Our focus in this article will be on traditional 401(k) plans as they are the most common.
[2] Subject to annual limits and according to the age of the employee.
[3] Each contribution would grow by a factor of (1+r)n with ‘r’ being the average return on investment to be obtained for each period and ‘n’ being the number of periods until distribution.
[4] In a future article we will describe the different types of savings plans and how some might be more efficient than others depending on the specific circumstances.