HAPPY 401(k) NEW YEAR

January 2005

Effective 1/1/2005, the 401(k) contribution limit has been increased to $14,000. Catch up contributions have also been increased to $4,000, so you can now contribute $18,000 to your 401(k) if you are over age 50. If you are a member of a SIMPLE plan, the elective deferral limit has now increased to $10,000. It was only a few years ago that the maximum amount that could be contributed to a 401(k) was $10,000. Whereas it is the New Year, you may need to alert your payroll department to insure that you are deducting the maximum amount from your paycheck.

You may however question this advice as you have read articles that suggest you may not want to maximize funding of your 401(k). This position argues that the benefits of a 401(k) plan have been reduced because the spread between ordinary tax rates, 35%, and rates on after-tax investment income, 15% on qualifying dividends and capital gains, is so great. Further, if you assume tax rates go up in the future, the funds withdrawn will be taxed at an even higher rate than the benefit received when originally contributed. Another supposed negative of 401(k) plans is that you invest in the employer-selected investment options and you may be able to do better on your own. It is suggested that you will be better off to hold your funds in an after-tax account.

Can a significant increase in tax rates eliminate the benefit of a 401(k)? Answer: not even close. Our research reveals that it would take a 20% increase in tax rates, from 35% to 55%, to overcome the tax and compounding advantages of a 401(k) plan. We reach this conclusion without considering any of the return on any employer-provided match to your 401(k). We must recognize the building pressure to increase income tax rates. These increases will likely be nominal, not a revolutionary number like 55%. If a need for substantial tax increase did arise, it is just as likely that the taxes would be in a currently unknown form such as a value-added tax which would not impact savings.

And, if you need further encouragement, for the professionals - doctors, lawyers, and accountants or those entrepreneurs who have guaranteed debt - an employer-provided pension plan such as a 401(k) is a time- and court-tested protection against tort liabilities. Fund your 401(k) as much as you can and at least enough to secure the maximum employer match!!

We do recommend that you review your pension holdings and reallocate your fixed income investments into your tax deferred account. Fixed income investments are still taxed at ordinary rates of 35%. Putting fixed income into your 401(k) and holding dividend producing or capital gain type investments in your after tax account results in the most tax efficient allocation of assets.

Call your payroll person today and make sure you are maximizing your savings in your company pension plan. Call us at 302-656-6632 with any questions, we at Cover & Rossiter will be happy to help. Or, you can email us at Coverrossiter@coverrossiter.com.