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We receive a number of e-mails from workers who are
upset that their new employer won't let them start contributing to the 401(k) plan right
away.
These workers want to know what is the best
way to keep saving in the interim.
When you start a job with a new company, there's a good
chance you'll be in this situation. More than one-third (41.6 percent) of employers
surveyed in 2000 required workers to wait six months or more before they could participate
in the 401(k) plan. Just over one-quarter (27.2 percent) had a one-year waiting period,
the longest permitted by law, according to a study by the Profit-Sharing/401(k) Council of
America (PSCA).
So how do you keep saving for retirement? It's a
very good question. In order to answer it, you need to first answer this one: Are you
concerned about the lost tax deduction or the lost savings opportunity?
Your answer will help direct the strategy you choose to
keep your savings program going. There are tax-deductible and nontax-deductible
strategies.
The Cost of Missing
There's a good reason why you should think about the impact
of interruptions on your retirement savings. If you don't, you could be hurting your
future.
Missing a year early in your working career will have the
greatest impact on your retirement balance because you will miss out on compound interest,
said Bob Francis, president of corporate markets with ING-Aetna Financial Services.
"The front-end deposits (and growth on them) represent
the biggest share of the ending account balance," said Francis.
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"The front-end deposits (and
growth on them) represent the biggest share of the ending account balance."
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— Bob Francis,
president of corporate markets, ING-Aetna Financial Services.
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Here's how compounding works. Suppose you're 25 years old
and make a one-time contribution of $2,000 to a 401(k) plan with a 50 percent
employer match. The total amount contributed would be $3,000. If you got an 8 percent
annual return, in 30 years, the $3,000 would grow to about $30,000.
Now let's look at what that same $3,000 contribution would
be worth if you made it at age 45. In 10 years, it would only grow to about $6,500.
Those numbers are a compelling reason to figure out a way
to save.
Tax Strategies
If getting a tax deduction is your big concern, you
probably have only one alternative: making a tax-deductible contribution to a traditional
IRA. But, if you contributed to a 401(k) or other employer-sponsored retirement plan at
another employer during the tax year, you can only make a deductible contribution to an
IRA if you meet the income requirements.
Also, the maximum IRA contribution limit is $2,000 a year,
well below the 401(k) pretax contribution limit of $10,500 for 2001.
Savings Strategies
Retirement experts interviewed for this article said that
while a tax deduction is attractive, it's more important to make sure you don't stop
saving.
"A concern I would have is the loss of (savings)
momentum," said Elise Pilkington, assistant director of retirement and investor
services with the Principal Financial Group, a 401(k) plan provider.
Workers who don't save regularly may find that the cost of
their lifestyle rises to match their income. "Could you adjust if you jumped back in
(to saving)?" she asked.
Here are strategies for maintaining your savings rate while
you're waiting to become eligible for your 401(k).
IRA: Contribute to an IRA. Anyone with earned
income can contribute to an IRA. As explained above, if you participated in an
employer-sponsored retirement plan at any time during the year, your income level will
determine whether your contribution is deductible and to what extent.
Even if you can't make a tax-deductible contribution to a
traditional IRA, you can still make an annual contribution of $2,000 to the account and
take advantage of tax-deferred growth.
A number of retirement experts recommend that instead of
contributing after-tax money to a traditional IRA, consider a Roth IRA, providing
you meet the income limits. Here's why: Both accounts are funded with after-tax dollars
(you can't deduct your contribution), and both accounts grow tax-deferred. The difference
is that you won't have to pay tax on your withdrawals from a Roth IRA, if you meet the
conditions, whereas you do have to pay tax on your earnings when you take withdrawals from
a traditional IRA.
Double Your Contributions: Another possible strategy
is to double your contributions when you finally can participate in the 401(k). Here's
how: While you're waiting to become eligible, open a savings account and deposit the money
you would contribute to the 401(k) if you could. When you become eligible for your 401(k),
double your contribution, providing you stay within the contribution limits
stipulated by the plan document. To make up for this drain on your income, gradually
withdraw the money from your savings account.
The drawback to this strategy is that the money in your
savings account won't compound over time, unless you can afford to leave it there while
you're contributing double to your 401(k).
Negotiate: You could ask your employer to compensate
you for the lost savings opportunity. Some employers offer nonqualified plans that you
might be able to contribute to. Or, you might be able to receive a bonus.
The drawback to this strategy is that it's often only for
top employees. But, given today's tight job market, it may be worth a try.
Open an Annuity: If you think the $2,000 annual IRA
contribution limit is too low, you could consider contributing to an annuity.
You use after-tax dollars to invest in an annuity but, like
an IRA, all your money grows tax-free. You pay income tax on the earnings when you receive
payments from the annuity. There is no federal maximum contribution limit, and the limits
set by individual providers tend to be high (over $100,000).
But, you also have to consider that annuities generally
carry higher fees than other investments because of the guarantees they provide.
Buy Growth Stocks: If you feel comfortable making
your own stock picks, you could do what Virginia Morris, author of The Essential Guide
to Your 401(k) Plan, recommends — buy growth investments that you will own for 10
years or longer. "Don't look for stocks that provide income (dividends)," she
urged.
Over time, hopefully the stocks will appreciate, and you
only pay tax when you sell them. You will owe long-term capital gains tax, which for many
folks will be less than their normal income tax rate.
If you opt for this strategy, you must be comfortable with
the relatively high level of investment risk you will be taking.
Younger Than 21
Employees under 21 may have to wait longer than one year to
become eligible to participate. Many 401(k) plans exclude these workers figuring that they
will likely change jobs soon, which complicates administration of the plan.
If you're in this situation and want to start saving, try
an IRA, Pilkington says. If you remain ineligible for the employer-sponsored plan for the
entire tax year, you will be able to make a fully deductible contribution to a traditional
IRA.
But, don't overlook the Roth IRA and the tax advantages it
offers at retirement, Pilkington said. This may be even more beneficial; it depends on how
badly you want the tax deduction now.
Other strategies listed in the section above might also
appeal to you. |
