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New Tax Law Changes and Your 401(k) and Retirement Accounts

Recent legislation gives you the opportunity to build greater personal wealth than you could previously, by putting more of your income in your pockets and letting you save more for retirement. 

The Economic Growth and Tax Relief Reconciliation Act of 2001 is a 10-year, $1.35-trillion package. It includes the biggest tax cut since 1981 and the most sweeping changes to the tax system since the Tax Reform Act of 1986.

Your taxes, paycheck, and retirement savings will be significantly affected by this cut. As a result of the new law, you might be able to pay less in taxes, save more, and retire earlier.

Lower Tax Rates

The law created a new 10% tax rate bracket that applies to a portion of income that was previously taxed at 15%. The new tax rate directly impacts most people´s paychecks. Bottom line? More take-home pay. The chart below gives you an idea of just how much more.

Estimated Tax-Cut Pay Raise
Estimated Tax-Cut Pay Raise

Based on tax margins and deductions for 2000 compared with estimated margins and deductions for 2002, as of November 2001.

Tax rates drop about 1% a year through 2006. The table below shows how the old rates will decrease over time.

Tax Rate Schedule
Estimated Tax-Cut Pay Raise

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Increased Contributions

Whether you have a 401(k), 403(b), 457, SEP, or SIMPLE, the maximum dollar amount that you can save in your plan increased with the new tax law. All of these plans are called "salary reduction" plans, because contributing to them reduces taxable income. The chart below shows the new dollar limits one can save each year:

New Maximum Dollar Limits
New Maximum Dollar Limits

*Indexed for inflation in increments of $500.

As of 2002, the total amount you and your employer can contribute to your defined contribution plan is limited to the lesser of $40,000 or 100% of your total compensation.

Under the old law, the maximum you and your employer could contribute to your defined contribution plans was limited to the lesser of $35,000 or 25% of your total compensation.

You also can save more in an Individual Retirement Account (IRA). Under the new law this maximum increases as shown in the chart below.

IRA Contribution Maximums
IRA Contributions Maximum
*After 2008, the limit will be indexed for inflation in increments of $500.

Since you'll have more in your paycheck from the tax cuts, and the retirement plan maximums have increased, why not consider contributing the maximum to your retirement account? Even if you can't afford to contribute the maximum to your plan, make the decision to take this tax break and give your retirement plan a raise.
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Catch-up Contributions

The new law allows you to contribute more than those maximums each year if you're 50 or older by the end of the plan year. The law requires that your contribution does not exceed your total compensation and that you have contributed the maximum to your plan by the end of the plan year. Listed below are the catch-up maximums through 2006.

Catch-up Contribution Amounts
Catch-up Contribution Amounts
*After 2006, amounts will be indexed for inflation in increments of $500.

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Tax Credits for Low- and Middle-Income Savers

The 2001 tax relief act created a tax credit for low- and middle-income savers.

The credit is available from 2002 through 2006, and will be provided to low- and moderate-income savers who make salary reduction contributions to eligible retirement savings plans.

Claim the tax credit on the individual's tax return, and apply it to the first $2,000 in contributions. The tax credit applies to contributions to regular retirement plans - such as 401(k), 403(b), 457, SIMPLE, and SEP plans - as well as to regular and Roth IRAs. The table below shows what kind of credit one might be eligible to receive.

Tax Credits for Savers
Tax Credits for Savers
This credit is in addition to any other tax savings one receives on contributions over the year.

Even saving less than $5 every workday - the cost of a cup of coffee and a pastry - can mean big savings over time. Look at the chart below to see how savings add up.

Growth of $100 a Month over Time
Tax Credits for Savers
Assumes 8% return, compounded monthly, on an investment of $100 a month, and no deposit increases.

If you are among those who qualify for the tax credit, you're really getting a triple tax break.

How? First you save on taxes because the money you save in your retirement plan comes out of your paycheck before it is taxed. You pay taxes only on the amount that remains, and that means a smaller tax bite out of your paycheck.

Second, the money in your plan grows tax-deferred. That means you don't pay taxes on the income your investments generate until you withdraw the money.

Finally, the new tax credit is like getting a gift certificate to apply toward taxes you owe come tax time.

And the best part of all? You get all these tax breaks while saving for a bright retirement.

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Easier Distributions

Withdrawing money from your account is called taking a distribution, because the money is distributed to you. When taking a distribution, proceed with care to avoid adverse tax consequences.

If you have to take a distribution from a retirement plan, a rollover might be your best bet. As the name implies, a rollover is "rolling over" your money from your retirement plan account into another kind of account, like an IRA.

More than 40% of American job changers choose to spend their retirement money instead of rolling it over. This is a costly mistake. They must pay a 10% penalty tax, and the cost of lost savings could be huge.

The best option is to roll the money over into a tax-deferred retirement plan, such as the new employer's plan (if rollovers are allowed) or an IRA. If you are in this kind of situation, consider consolidating your retirement plans for administrative convenience and ease of tracking.

Beginning in 2002, rollovers between a variety of retirement plan types are allowed. The chart below shows you what you can roll from and into under the 2001 tax law.

Allowable Rollovers between Plan Types
Tax Credits for Savers
* Receiving plan must agree to separate accounting; must be direct trustee-to-trustee transfer.

The ability to roll money between plan types is a great benefit of the new tax laws. Rollovers can be complex, however, so check with your plan administrator or financial advisor if you have questions.

After-Tax Contributions

If your current plan allows after-tax contributions, the new law allows you to roll these contributions into a new employer's 401(k) or into an IRA, if you have to take a distribution. With the exception of IRAs, the receiving plan must agree to separate accounting, and it must be a direct trustee-to-trustee transfer.

Rollovers From a Spouse's Plan

In the past, options were limited - if your spouse died, leaving you a balance in his or her retirement plan, you were required to take a lump-sum distribution. Unless you rolled that money into an IRA, you could face substantial tax consequences.

The new laws offer you another alternative - if you are a participant in a 401(k), a 403(b), or a 457 plan, you may roll the money into this plan. This option provides another way to shelter the money from current taxes.

Next Steps

Managing your finances and your future is very important. One of the best ways to do this is by acquiring financial knowledge and skill. Below are instant actions you can take today. Check them off one by one to instantly improve your retirement future!

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