Using Your Retirement Plan

Perhaps the most important employee benefit is participation in a 401(k) plan or other deferred compensation retirement plan. Some employers require you to work for a minimum period before being allowed to participate in the plan.

A 401(k) plan is the most common type of defined-contribution plan. With 401(k) plans, your employer deducts a portion of your income, before taxes, and deposits these contributions in an account in your name.

Your contributions grow tax-deferred in the account until you begin to take out the money. Generally, you may begin to take distributions from a 401(k) or similar retirement plan, free of early-withdrawal penalties, when you reach age 59-1/2.

For 2008, you may contribute up to the lesser amount of $15,000 or 100% of your compensation to a 401(k) or similar plans. These plans include 403(b) and 457 plans. Your employer may contribute an additional amount up to a combined total amount that is the lesser of $46,000 or 100% of your compensation.

The Economic Growth and Tax Relief Reconciliation Act of 2001 authorized larger contributions to 401(k)s and other retirement plans beginning in 2002. A catch-up provision in the law allows workers who are age 50 or older to make larger contributions. The 2008 contribution limit for those who are 50 years old or older is $20,500 (also indexed for inflation).

The following table shows authorized increases in yearly contribution limits to 401(k), 403(b) and 457 plans through 2006. Limits for later years are indexed to inflation in increments of $500:

Let's take a look at the benefits of saving with one of these tax-deferred accounts. Assume you make a contribution of $13,000 for each of the next 20 years and you are in the 25% income tax bracket. You contribute to the account once a year at the beginning of each year. If you earn an average yearly rate of return of 8%, these contributions grow to $642,498 in 20 years.

On the other hand, if you paid taxes on these contributions each year at 25%, your contributions grow to $506,905 -- over $135,000 less. As you can see, saving with a tax-deferred account makes a huge difference over time.

Once you begin taking distributions from a 401(k) plan, you may be in a lower income tax bracket. In addition, since you usually withdraw a portion of the account balance each year, the remaining balance continues to benefit from tax-deferred growth.

If your employer makes matching contributions, a 401(k) or similar retirement plan is an even better deal. Matching contributions encourage you to contribute to a retirement account.

Generally, it pays to contribute as much as you are allowed to a 401(k) or similar employer-sponsored retirement plan, particularly if your employer makes matching contributions.

The above information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.