Copyright © 2008, The McGraw-Hill Companies, Inc.
Example 7.2.1 Sarah has $3,000 that she wants to invest in an IRA. She expects
that this money will earn 9%, and does not expect to withdraw the money from her IRA
for another 40 years. Assuming that she will pay a 30% rate for combined state and
federal income taxes, how much will she have after taxes if she invests in (a) a Roth
IRA or (b) a traditional IRA.
(a) Compounded at 9% for 40 years, her $3,000 would grow to:
FV PV (1 i)n
FV $3,000(1.09)^40
FV $94,288
No taxes will be owed on this money when she withdraws it from a Roth IRA.
(b) Her money would grow to the same amount in a traditional IRA, but then she would
have to pay taxes on it when withdrawn. Paying 30% of this in income taxes when it is with-
drawn would leave her with 70% of this after taxes, or (70%)($94,288) $65,960. (With the
traditional IRA she might be able to deduct her contribution on her income taxes, resulting
in a (30%)($3,000) $900 savings on her taxes now.)401(k)s
401(k)s are a type of retirement account offered as a benefit by employers. Workers con-
tribute to their 401(k) accounts by payroll deductions; money contributed to a 401(k) is
not included in taxable income, and so putting money into a 401(k) can lower your overall
income tax bill.^3 As in a traditional IRA, the money in a 401(k) account grows tax- deferred,
and is subject to income tax when it is withdrawn from the plan. Withdrawals from a
401(k) are subject to restrictions similar to the restrictions on traditional IRAs. There are
also limits on how much money can be contributed to a 401(k) plan per year, but these
limits are high enough that they don’t really affect most workers.
When a company sets up a 401(k) plan for its employees, it generally selects a plan
administrator such as a bank, insurance company, or mutual fund company. Employees control
how their money is invested by choosing from a selection of mutual funds offered by the
administrator for the company’s plan. In many, though not all cases, the employer offers some
matching of the employee’s contributions, up to some maximum. For example, a company
might offer to match contributions 50% on the dollar up to 8% of salary. (The limit refers to the
amount that can be matched, not to the amount of the employer contribution. In fact, the most
this company will contribute would be 50% of 8%, or 4% of salary.) The money contributed by
the employer, and the investment earnings on that money, may be subject to a vesting schedule.Example 7.2.2 Lisette makes $26,735 annually working for Shender Chemical Corp.
The company offers a 401(k) plan with 75% matching up to 6% of salary. How much in
total would Lisette have deposited to her 401(k) each year if she decides to contribute
(a) nothing, (b) 4%, or (c) 10%.(a) If Lisette doesn’t contribute anything to the plan, neither will her company. The answer
here is $0. She misses out entirely on both on the tax savings and the “free money” that the
plan offers.
(b) 5% of her annual salary is (5%)($26,735) $1,336.75. The company will match
75% of this amount, or (75%)($1,336.75) $1,002.56. In total, this makes $1,336.75
$1,002.56 $2,339.51.
(c) 10% of her annual salary is (10%)($26,375) $2,637.50. The company will not
match this entire amount, though. The company match will only apply to the fi rst 6% of her
salary, so the match will be (75%)(6%)($26,375) $1,186.88. This totals to $2,637.50
$1,186.88 $3,824.38.Lisette will have to decide for herself how much to contribute to her 401(k), based on her
present income needs and long-term financial planning goals. A case can easily be made,7.2 Details of Retirement Plans 317(^3) As with anything involving tax laws, there are some exceptions.