Shelter From April's Showers

By Barbara Rudolph

For five sweet years the individual retirement account was Everyman's tax shelter, providing a tax-deductible savings plan enjoyed by millions of Americans. But as the April 15 income-tax deadline approaches, that once sturdy shelter is leaking badly. Because of tax reform, high-income IRA holders can no longer claim deductions on contributions to their accounts. Many taxpayers, though, are not despairing; they are switching to another tax- deferred investment vehicle that has become an attractive alternative to the IRA. Its cryptic name: the 401(k). Says Christine Okenica, benefits coordinator at LeBoeuf, Lamb, Leiby and MacRae, a New York City law firm: "Today 401(k) plans have the same magic that IRAs had before tax reform."

Unlike IRA accounts, 401(k) shelters -- named for the section in the Internal Revenue code that defines them -- are set up by companies for their workers. An employee may contribute as much as 20% of his salary to the plan, up to a maximum of $7,313 a year. IRA contributions are limited to $2,000 a year. The 401(k)'s biggest break: contributions are taken from pretax income, with taxes deferred until the money is withdrawn. For most single taxpayers earning more than $25,000 and married couples with incomes in excess of $40,000, IRA contributions are made with after-tax income. Another appeal of the 401(k) is that the accumulated earnings grow tax free, as they do in an IRA. Some firms also match 401(k) contributions. The companies hire financial experts to manage the funds, which are put into such investments as stocks, bonds and certificates of deposit.

While 401(k) plans have been around since 1978, they have caught fire only in the past few years. According to Hewitt Associates, a benefits-consulting firm, about 90% of all firms with 1,000 or more employees now provide 401(k) plans, up from 39% in 1983. In that year less than 40% of all employees eligible to make 401(k) contributions did so. Now at least two-thirds do. Greg Cole, general manager of Lips Propellers in Oakland, contributed $6,000 to his 401(k) plan last year. Says he: "I don't think there's a better deal out there."

Employers are enthusiastic about 401(k)s because they represent an easy and inexpensive employee benefit. Smaller firms that are hard pressed to provide a pension plan for their workers can, at a modest cost, set up a 401(k) in which employee contributions are not matched. Large companies find that they can save money by scaling back their basic pension plans and introducing 401(k) programs.

Still, the shelters are not constructed to everyone's taste. Some workers are concerned that their savings cannot be easily retrieved, as is the case with IRAs. According to the tax rules governing 401(k)s, employees can withdraw their money before age 59 1/2 only if they suffer from a disability or a hardship, which the IRS has traditionally interpreted to mean something as serious as costly medical expenses. They must also pay a 10% penalty to retrieve their funds. One way to withdraw the money without paying the penalty is to borrow against one's 401(k) savings. But employees must pay market-rate interest (currently about 9%) and repay the loan within five to ten years.

The proliferation of 401(k) plans could help bolster America's anemic savings rate (only about 3.5% of income last year). Yet the impact could be limited, since participation in 401(k) plans varies sharply with salary level. Some studies show that of the employees in the lower two-thirds of a company's salary scale, as few as 50% join 401(k) plans. However attractive, these newfangled tax shelters cannot change certain basic realities. For workers with school-age children, large mortgages and limited income, saving is often a luxury they can hardly afford.

CHART: TEXT NOT AVAILABLE

CREDIT: TIME Chart by Cynthia Davis

CAPTION: THE 401(K) ADVANTAGE

DESCRIPTION: Amount accumulated from $2,000 annual deposit in 401(k) plan and in taxable savings plan at several time intervals.

With reporting by Wayne Svoboda/New York