401k Plans Cut Retirement Benefits
QUESTION: In all of your columns about 401k salary reduction plans, you have never discussed the negative effects that these plans have on your retirement benefits, which I would think have to be based on your “reduced” salary level rather than your actual income. Am I right?--S. S.
ANSWER: Yes, you are. In most cases, company benefits that are tied to salary levels are reduced accordingly when you agree to defer part of your salary this way. So if you are contributing to a 401k salary reduction plan in the years that your employer uses as the base to determine your retirement or death benefits, for example, your benefits would be based on your salary minus your contributions.
Hewitt Associates, a consulting firm headquartered in the Chicago area, says the average deferral by employees into salary reduction plans is 4% to 5% of their salary. A typical employer-provided pension plan bases an employee’s retirement pay on the average amount that he or she earns in the five highest-paid years.
So, if your peak salary was $30,000 and you were contributing $1,500 a year to a 401k salary reduction plan, your benefits would be based not on the $30,000 figure but on the lower $28,500 figure.
Enough employees have protested this reduction in their salary base for benefit purposes that some employers are revising their salary reduction plans. In these revised plans, employees may continue to set aside a portion of their salary, tax deferred, until the money is withdrawn but have their benefits based on their actual salary.
Employers are just starting to add clauses to their plans. So it is too soon to know whether the movement will spread to the majority of U.S. employers.
Check with your company personnel department for details.
Q: After moonlighting for three years in a consulting job, I have decided to start my own company. I remember hearing some time ago that Congress had passed a law to encourage new small businesses through something called Small Business Stock. Can you tell me what that is and what its purpose is?--J. K.
A: Issuing this so-called Small Business Stock instead of regular corporate stock allows you to better hedge your bets against the prospect that your business will fail. If you invest $10,000 in Small Business Stock in your business and it fails, you could write off the full amount in the year that your stock is sold at a loss or becomes worthless. So, if you’re in the 50% tax bracket, the loss under this provision of the tax laws would be worth $5,000 in tax savings to you. Were your investment in the form of regular corporate stock, your write-offs for the same year would be limited to about a tenth of that amount.
This aid for small businesses is spelled out in Section 1244 of the Internal Revenue Code. Only companies that receive $1 million or less for their shares are permitted to issue the stock. And $50,000 is the maximum yearly loss that may be claimed ($100,000 on a joint return).
For more details, contact your accountant, lawyer or the Small Business Administration.
