Employer Plans, Part 2Employer Plans,
Part 2

How Retirement Plan Contributions Affect Your Take-Home Pay

When you contribute to your employee retirement plan, you divert a portion of your income into retirement savings, away from your take-home pay. From the example above, still assuming your annual income is $60,000, your $3,000 contribution to your retirement plan would reduce your gross (before taxes) take-home pay to $57,000.

The Tax Benefits

Lowering your take-home pay may not sound all that appealing, but you get two tax benefits for making the sacrifice:

  1. Tax-deferred earnings. The money you contribute to and invest in your defined contribution plan grows tax free until you retire and begin withdrawing money from the plan. At that point, you begin paying income tax on the withdrawals. In other words, your taxes are “deferred” to a later time, when your income tax rate might be lower than when you were working.
  2. A lower taxable income. Because your contributions are not taxed now, but later, your taxable income is lowered by the amount of your contributions. For example, if you earn $60,000 and contribute five percent, or $3,000, to your defined contribution plan, your taxable income is $57,000. In other words, you would calculate your annual income tax on $57,000, not $60,000.

Investment Choice

Your employer will provide you with a choice of investments you can make in your defined contribution plan, usually money market, mutual funds, stocks, and bonds.

Penalty for Early Withdrawals

If you withdraw money from your defined contribution plan before 59 years of age, the earliest age you may withdraw, you will pay a 10 percent penalty fee on the amount of the early withdrawal in addition to income tax on the withdrawn amount.

Exceptions: Hardship Withdrawals

Some employer retirement plans allow for hardship withdrawals, penalty-free, for medical expenses not covered by your health care plan. Check with your employer on whether this is the case with your retirement plan. Some pretty strict requirements usually have to me met to qualify for a hardship withdrawal. To avoid a potentially costly error, be clear on what your financial responsibilities are before you make an actual withdrawal. Employers may also allow the hardship withdrawals listed below (see GuideTo401kHardships.com. “Information on 401(k) Hardship Withdrawals.” Retrieved from http://www.guideto401khardships.com/ on September 7, 2010). Again, be clear on what requirements you must meet before you make any withdrawals from your employer retirement plan.

  1. Un-reimbursed medical expenses.
  2. The purchase of your first home (the one you would live in; not a rental or investment home).
  3. Payment of college tuition and some related costs, such as room and board.
  4. Payments on your primary residence (not rental or investment property) to prevent eviction or foreclosure.
  5. Funeral expenses.
  6. The repair of your primary residence.

Important Considerations for Hardship Withdrawals

Making a hardship withdrawal may have several implications on the long-term financial well-being of you, your family, and your child with ongoing special needs. Consider them carefully (see IRS.gov. “Retirement Topics—Hardship Distributions.” Page last reviewed August 5, 2010. Retrieved from http://www.irs.gov/retirement/participant/article/0,,id=211439,00.html on November 19, 2010, and IRS.gov. “Retirement Plans FAQs regarding Hardship Distributions.” Retrieved from http://www.irs.gov/retirement/article/0,,id=162416,00.html on November 19, 2010.).

  1. You will have to pay income tax on the amount withdrawn from your employee retirement plan.
  2. You reduce the amount of your retirement savings by the amount withdrawn.
  3. You may withdraw only your contributions, not your employer’s matched contributions.
  4. The withdrawal may not be higher than the hardship expense. For example, it may not be more than the actual unreimbursed medical expenses.

If you’re strapped for cash, a hardship withdrawal might seem like the answer to your financial hardship. But consider the long-term consequences.

First, do you want to potentially reduce your retirement income? And second, do you expect your financial situation to improve? If you don’t think it will, what is the possibility of finding yourself strapped for cash again?

If you think your financial situation might improve and you are not contributing the maximum amount allowable to your retirement plan, you may have the opportunity to “pay yourself back” by making higher contributions in the future.

Catch-Up Contributions

The IRS allows individuals age 50 and over to make annual “catch-up” contributions to their employee retirement plans. The IRS limits the amount of catch-up contributions. As of 2010, the annual limit is $5,500. Other restrictions to making catch-up contributions apply. For more information on catch up contributions, take a look at the IRS article Retirement Topics—Catch-Up Contributions. It is very important you fully understand every financial consequence to a hardship withdrawal. If you are considering one, speak to someone at your company knowledgeable about them. Also, visit the IRS Web site and take a look at the article, Retirement Topics—Hardship Distributions.