Millions of employees will need to make some decisions soon about whether to participate next year in their employer’s 401(k) retirement plan and “flexible-spending arrangements” for dependent-care and medical expenses.
This is the time of year when most employers open enrollment for 401(k)s and FSAs for the coming year.
Decisions about whether to participate in a 401(k) next year and how much to contribute are complicated by the new retirement saving options created by the recently enacted Taxpayer Relief Act of 1997. Congress made more workers eligible to make tax-deductible contributions to conventional individual retirement accounts. And all but the wealthiest of workers will be eligible to take advantage of a new type of non-deductible IRA (known as a Roth IRA) that allows tax-free withdrawals.
But despite all the hoopla in the financial community over the IRA changes, most workers will find that a 401(k) remains the best option for retirement savings. And most employees will find that FSAs remain the best way to reduce their child-care and out-of-pocket medical expenses.
In addition, some middle-income workers will find that participating in 401(k)s and FSAs will help them qualify for some of the new law’s most valuable benefits. Many of the new benefits, including the tax credits for families and college expenses, have income-eligibility limits. For some individuals bordering on the income limits, earmarking salary to 401(k)s and FSAs will help push their incomes below the eligibility limits.
– 401(k) vs. IRA. To be sure, Congress did make some attractive changes to IRAs. Beginning next year, more workers will be eligible to make tax-deductible contributions to traditional IRAs. The new law raised the income-eligibility limits for IRA deductions for workers who participate in a 401(k) or are covered by some other retirement plan.
The tax benefits of 401(k)s are similar to those of traditional IRAs, in which contributions are deductible and money in the account escapes tax until withdrawn.
By contrast, contributions to the new Roth IRA won’t be deductible. But withdrawals will be completely tax-free as long as the account has been open for more than five years and you’re over age 59 1/2 or are using up to $10,000 to buy your first home. In many cases, the Roth IRAs will provide greater tax savings than fully deductible IRAs.
But most workers will come out ahead with 401(k)s.
The main reason is the extra money most employers kick into the pot. Most companies will contribute 50 cents or more for each dollar an employee contributes to a 401(k). The benefit of receiving that matching grant will far exceed the extra tax savings that the Roth IRA can sometimes provide.
What’s more, 401(k)s provide a way to shelter more of your income. While contributions to IRAs are limited to $2,000 a year, most companies allow employees to contribute up to 10 percent of their salary to a 401(k). By law, the maximum contribution currently allowed to a 401(k) is $9,500 a year.
If your employer matches your 401(k) contributions, tax advisers generally recommend earmarking at least the amount necessary to take maximum advantage of the matching contribution. “You may even want to go further, but you certainly want to make the matching limit,” said William Goldberg, partner in charge of the personal finance planning practice at the accounting firm of KPMG Peat Marwick in Houston.
For example, if your employer provides matching funds for the first six percent of your salary contributed to a 401(k), you should try to earmark at least six percent of your salary to a 401(k).
Regardless of whether you participate in a 401(k), you’ll still be eligible to take full advantage of the Roth IRA if you meet the income-eligibility requirements. Eligibility starts to phase out for those with adjusted gross incomes above $150,000 on a joint return and $95,000 on a single return.
Workers who decide to participate in a 401(k) will still be able to take full advantage of a deductible IRA next year if their income is below $50,000 on a joint return or $30,000 on a single return.
– Dependent and medical-care accounts. FSAs are well worth considering if you have a child in day care or if you expect to have medical expenses that won’t be reimbursed by your regular health plan.
The tax benefits of these accounts can effectively reduce the cost of day-care or out-of-pocket medical expenses by hundreds of dollars a year.
For most employees, FSAs are the only way to get a tax break for out-of-pocket medical expenses because it’s so hard to qualify for the itemized medical deduction. (The medical deduction is available only for expenses that exceed 7.5 percent of adjusted gross income.)
When you sign up for an FSA, you’ll need to designate how much you want deducted from each paycheck next year and placed into your dependent-care or medical-care FSA (or one of each). Any salary set aside in FSAs escapes both income tax and Social Security tax.
During the course of the year, you’ll be able to withdraw funds from the FSA to pay eligible dependent-care expenses or medical bills that aren’t reimbursed by insurance, such as annual deductibles and co-payments to physicians.
Up to $5,000 a year can be set aside in dependent-care accounts. There is no legal limit on contributions to medical-care FSAs, but most companies limit annual contributions to $2,000 to $3,000.
When figuring how much to set aside, be conservative because any unspent funds in your FSA at the end of the year are forfeited, as mandated by the federal law governing FSAs.
