401(k), a cousin of the well-known IRA, is better in many ways
Boston — For many American workers, wage cuts and give-backs are fighting words these days. But for many others, a plan to cut their wages and salaries has them lining up at the personnel office asking to be included. They don't even seem to mind that it's sometimes called a ''salary reduction plan.''
The official, though more arcane, title is taken from its Internal Revenue Service code number: 401(k), and by that name it is one of the hottest employee benefits of the past year.
''We're getting a very big response from our employees,'' said Robert F. Thurrell Jr., director of corporate benefits at the John Hancock Mutual Life Insurance Company in Boston. Actually, Mr. Thurrell added, the plan hasn't even begun yet; payroll withdrawals will start with the first pay period in January. Still, about 80 percent of Hancock's eligible employees have signed up.
What they are signing up for is a plan that will take as much as $30,000 a year out of their paycheck, before any federal or state (in most states) tax obligations are figured. For an employee in the 30 percent tax bracket, this means a $100 401(k) contribution would reduce take-home pay by only $70, even less if the state tax burden is eased. Not only is all the money contributed on a pretax basis, it accumulates interest tax-free until retirement, when the individual is expected to be in a lower tax bracket.
Because it relies on the employer's initiative, the 401(k) has not gained the public attention enjoyed by the individual retirement account, even though the 401(k) is, in many ways, a better retirement savings vehicle.
The most obvious difference is the size of the contribution. The most that can be put into an IRA is $2,000 a year, or $2,250 in a spousal IRA if either the husband or wife is not working.
Although contributions to an IRA can be deducted from federal income taxes even if the employee does not itemize, he pays social security taxes on that $2, 000. He doesn't pay social security taxes on the money set aside in a 401(k). Also, IRA contributions are not deductible from many state income taxes.
Most employers offering 401(k) plans also make a contribution to each employee's savings. The size of the company ''match'' may be as low as 1 percent of wages, but that can raise worker participation in the program to 80 percent or better. Employers with payroll-deduction IRAs do not include a matching contribution.
The 401(k) also benefits the employer, because payroll taxes are based on the workers' post-401(k) earnings, saving the company money as well as providing some goodwill. In addition, contributions by the company are deductible from its income taxes.
There are 401(k) plans to which the employer does not contribute, as well as cash-option profit-sharing plans that are primarily employer contributions, but the most common type uses both employee and employer contributions.
(There is another salary-reduction option, one that is particularly suited to smaller employers that do not have enough employees for a 401(k). Known as the VERSA, or voluntary employee retirement savings account, it combines most of the advantages of a 401(k), except that any of the principal, but not the interest, can be withdrawn at any time without penalty.)
Another advantage of a 401(k) can be seen at retirement. Qualifying lump-sum distributions are eligible for 10-year forward averaging, a tax-saving method that can cut as much as two-thirds off what you would otherwise pay Uncle Sam. The best that can be done with an IRA distribution is five-year income averaging.
These advantages have made it fairly easy for employers to ''sell'' the 401 (k) and use it as a basis for restructured pension plan programs that often include a ''cafeteria'' plan of other employee benefits and an eventual reduction of the company's contribution to its defined benefits pension plan.
''We look at the 401(k) as the foundation of the employee retirement savings program today,'' said Robert Gorman, director of marketing at the CIGNA Group, the Hartford, Conn., insurer.
For many insurance companies, accounting firms, mutual funds, and banks, the 401(k) has also been a boon, as they provide the legal, financial, and technical expertise companies need to set up and administer these plans. At many companies , the person who talks face to face with the worker is from one of these outside firms.
At these discussions, the worker is usually presented with three or four investment alternatives for his retirement savings. These usually include a flexible-premium deferred annuity with an interest rate guaranteed for at least one year, an equity mutual fund, a money market fund, and shares of the company's own stock. At many companies, the employer's matching contribution goes entirely to this option, providing another way for the company to build its own reserves of equity capital.
This, proponents of the IRA say, is one reason people should consider having both an IRA and a 401(k). With an IRA, you have the entire spectrum of banks, insurance companies, mutual funds, and everything else in the financial ''supermarket'' to choose from. Also, as long as you are willing to pay the 10 percent penalty and the taxes, you can withdraw the money at any time. With the effects of tax-free compounding of interest, this could make the IRA a good tax-sheltered savings vehicle in some instances.
''I think that we'll see more of the use of 401(k)s in addition to IRAs,'' said Andrew Lawlor, actuarial and benefits partner at Coopers & Lybrand, the accounting firm. ''I don't see the 401(k) as a trade-off with the IRA.'' Still, he says that if a person were to choose only one, the first choice would more likely be the 401(k).
Mr. Lawlor says an interesting aspect to the growth of interest in the 401(k) is the fact that not all the pertinent regulations have come from the IRS yet, and many companies are setting up the programs anyway. Sometime in the next few months, the IRS is expected to issue guidelines for the kinds of circumstances under which early withdrawals will be permitted without penalty. Most experts believe the service will permit withdrawals for three reasons: a down payment on a personal primary residence, college education costs, and emergency medical expenses.
''Based on informal commentary from the IRS, these will be permitted,'' Mr. Lawlor said.