401K DC

401 plans were first authorized by a section of The Tax Reform Act that Congress passed in 1978. It took several more years until the actual regulations were put into place. So, beginning in 1982, taxpayers were able to begin making contributions to their plans for the first time. It wasn't until 1991, however, that the final regulations were published.

The name of the program comes from the place where it is listed in the Internal Revenue Service tax code: section 401, paragraph (k).

Not every employee in DC is eligible; those who work for tax-exempt organizations, such as churches, public schools, or hospitals cannot participate. But for these employers, there are similar 403(b) plans available.

The basic idea of each plan is the same: your employer deducts a certain percentage of your gross earnings from each paycheck and puts it into a retirement plan for you. It is all done automatically, with the amount deducted reported to you on each paycheck stub.

Your automatic deductions are done on a pre-tax basis. This does not mean that they are "tax free," it just means that you do not pay taxes on these amounts until, ideally, you are at least 59½ years old, you retire, and you start to receive distributions from your plan. (There are certain instances in which you can receive distributions from your plan before you are 59½ years old, but you generally want to do this unless you have to.)

The tax-deferred contributions are invested in securities or stocks, and then allowed to grow until they are withdrawn when the participant retires. Unlike regular stock market investments, you are not faced with paying capital gains taxes when your 401k investments increase in value.

What does this mean right now, when you are making contributions to your plan? It means that your employer is reporting a lower adjusted gross income to your employer. Although you are still making the same amount of money, according to the IRS, you are making a smaller amount of taxable income and your tax liability is lowered. This reduces the amount of taxes you must pay at the end of the year.

For example, suppose that you receive a paycheck for $1,000. If you put $50 of that amount into a 401 k plan, your taxable income is only $950.

This is often considered one of the major benefits of a 401(k) plan. If you contribute enough to the plan, you might even put yourself into a lower tax bracket. In addition, because certain IRS credits, such as child tax credits, depend on a worker's adjusted gross income, you may even lower your taxable income enough to be eligible for additional credits, while saving for retirement at the same time.

Because you lower your adjusted gross income when you contribute to a 401(k) plan, you also lower the amount of state taxes you must pay (if your state has a state income tax).

Of course you have to pay taxes on this income when you retire. But since incomes often drop when people retire, you may be in a lower income bracket by then and pay less in taxes.

With pension plans from employers now a rarity, the 401k-retirement savings plan may well be the main source of retirement income for many people in DC. Utilize your human resources department to make sure you know what is available to you for retirement options, and that you understand your available benefits. Do not wait for them to come to you, because they probably will not.

Few middle- and low-income people are able to buy significant amounts of stocks and bonds on their own; most do not have a broker. Few will have Certificates of Deposits or large amounts of savings. Few in this category are able to put money into 402 plans, or even understand how to utilize them.

Of course, there are always Social Security payments. But if you rely exclusively on that, you are very likely to be disappointed. Social Security payments can be as low as several hundred per month. And unless the government radically changes the rules in the future, you are not likely to receive more than a few thousand dollars a month from Social Security payments, regardless of how much you earned during your lifetime.

If you have to live on Social Security alone, that could represent a radical drop from your pre-retirement income. You don't want to go from a middle-class lifestyle to poverty. Many of us dream that we'll be better off after we retire; few of us realize that without careful planning things could be worse.