TOOL A Benefits Primer for New Employees
You can customize this discussion to your organization’s benefit offerings, depending on what kind of health and retirement plans you offer. In addition to the benefit basics covered here, you also should be ready to discuss such things as vacation or paid time off, fitness or wellness offerings, discounts on products or services or other benefits that a new employee might need to know. Emphasizing these benefits can further strengthen a new employee’s perception that they made a smart choice when they came to work for you.
Your salary, income taxes and FICA
Most employees look at salary as the beginning and end of why they work. But salary is only part of the big picture. Based on December 2008 data, the U.S. Department of Labor estimates that salary accounts for 69.8 percent of an employer’s cost of compensating an employee. Employee benefits amount to an average of 30.2 percent of an employer’s cost per employee.
Let’s look at how your salary relates to the amount actually reflected on your paycheck, and what value employee benefits can add for you. First, you need to understand the deductions that automatically come out of your paycheck. Remember back to that first paycheck you received when you worked a retail job in high school? You had calculated how many hours you needed to work to afford that new video game or outfit—and then, reality hit. The check shrunk. Who was taking all of your money? Let’s review these deductions, because they form the foundation for understanding employee benefits.
Federal and state income taxes: Not every dollar you make is taxed by the federal government at the same rate. The Internal Revenue Service uses a progressive tax schedule, reflected in tax brackets. For example, if you hear your parents say they are in the 28 percent tax bracket, it does not mean they pay 28 percent federal income tax on each dollar of income. Here are the federal tax brackets for 2008 (assuming you are single):
If taxable income is over
... but not over
|... the tax is|
|$0||$7,825||10% of the amount over $0|
|$7,825||$31,850||$782.50 plus 15% of the amount over $7,825|
|$31,850||$77,100||$4,386.25 plus 25% of the amount over $31,850|
|$77,100||$160,850||$15,698.75 plus 28% of the amount over $77,100|
|$160,850||$349,700||$39,148.75 plus 33% of the amount over $160,850|
|$349,700||No limit||$101,469.25 plus 35% of the amount over $349,700|
Therefore, if you are earning $40,000 per year, you would pay federal income taxes of $4,386.25 plus 25 percent of $8,150 ($40,000 31,850), which equals $6,423.75. This simplified calculation does not reflect any reductions in the federal income tax you receive because of deductions for which you qualify, but it does give you an idea about how tax brackets work. In addition, depending on where you live, your state also probably taxes your income. You can find the income tax rate for your state at http://www.taxfoundation.org; search “state income tax rates.”
FICA: The initials stand for the Federal Insurance Contributions Act. It is the 1935 law that established the Social Security system. For purposes of payroll deductions, FICA has two components: Social Security (retirement, survivor and disability benefits) and Medicare (health coverage for the elderly). You pay 6.2 percent of your earnings (up to $106,800 for 2009) for the Social Security portion. You pay an additional 1.45 percent (with no cap) for Medicare. Your portion represents half of the total FICA obligation on your earnings. Your employer pays the other 7.65 percent. If you were self employed, you would pay the entire 15.3 percent (but you can deduct the employer portion as a business expense).
Retirement plan basics: 401(k) plans
A 401(k) plan puts the investing responsibility for retirement in your hands. You benefit from the upside of good investments, but also bear the risk of declining investments. Therefore, you should carefully analyze your investment options or seek professional advice.
At your age, you may wonder why you should save toward a date that’s more than 40 years in the future, especially when you need the money now to pay college loans, buy a car or move out of your parents’ house. You need to understand that compounding makes your investment grow faster, that pretax contributions mean $1 invested for less than $1 out of your pocket, and if you don’t participate, you may be giving up free money.
Compounding: When you contribute money from your paycheck to your 401(k) plan, you decide how the money is invested. Typically, the investment grows each year and you have more money in your 401(k) account. (Let’s ignore recent investment performances and think long term.)
This is compounding in a nutshell: Your investment earnings are added to your account balance to form a larger balance on which to earn future investment earnings, causing your overall investment to grow more rapidly. The longer the process works before you take your money, the higher your potential balance. As an example, in year one, you contribute $100 directly through your payroll to your 401(k) plan, and this money grows by 6 percent. In year two, your beginning account balance in your 401(k) account is then $106. If this larger amount ($106) grows by 7 percent in year two, you have $113.42 from your original $100.
You can calculate a rough estimate of how long your money will take to double by using the Rule of 72. Under the Rule of 72, if you divide 72 by your investment earnings rate, the answer is the approximate number of years it will take for your money to double. If your 401(k) account has an investment return of 6 percent, it will take 12 years (72 divided by 6) for your money to double. So, if you invest $100 this year, you will have $200 in 12 years. The amount you invest could double four times before you retire, and that does not account for any additional contributions you make in those years to help your account grow even faster.
A dollar that isn’t a dollar: When you make contributions to a 401(k) plan, you normally make them “pretax.” That means you do not pay income tax on the contributions until you take your distribution (which could be 40-plus years from now). Contributions are subject to the Social Security and Medicare taxes discussed above, but, to simplify our example, we will look only at the income-tax impact to you. If you earn $40,000 per year, the first $7,825 of your income is taxed at a 10 percent rate, the next $24,025 is taxed at a 15 percent rate and the remainder is taxed at a 25 percent rate. Say you decide to contribute $100 to your 401(k) plan. You would have received only $75 of that $100 in your paycheck because you would have paid $25 in federal income taxes. By making the contribution, the full $100 will be allowed to grow, compounding earnings until you receive a taxable distribution.
Free money: Many employers provide an incentive for employees to contribute to the 401(k) plan by offering a matching contribution. A matching contribution is money your employer contributes to your 401(k) account based on the amount of money you contribute. For example, let’s say your employer contributes 50 percent up to 6 percent of compensation. Using the hypothetical $40,000 salary above, for your contribution of $2,400 (which is 6 percent of $40,000) your 401(k) account receives $1,200 from your employer. That is $1,200 in free money. Even if you feel you cannot afford to contribute the full $2,400, contribute something. You leave 50 cents on the table for every dollar you do not contribute. Remember that dollar would only have been 75 cents of take-home pay—actually less if we accounted for state income taxes here too.
Retirement plan basics: traditional pension plans
A traditional pension plan puts the investing responsibility, and associated risk, in your employer’s hands—a positive feature. Generally, your benefit remains the same whether the underlying investments underperform or overperform expectations. However, traditional pension plans are not without risk for you. Many traditional pension plan benefits are not portable. They don’t go with you when you move to a different employer, meaning you would need to retire from the employer offering the benefit.
This feature makes that type of pension plan less practical with our more mobile workforce. In addition, as recent economic downturns have caused the assets put aside in traditional pension plans to decrease dramatically, many plans do not have sufficient resources to pay “guaranteed” benefits. If the Pension Benefit Guaranty Corp., a federal government agency, needs to take over your employer’s plans, “guaranteed” benefit levels may be limited.
Health care and other benefits
Health insurance: You’re young and healthy. You rarely, if ever, go to the doctor. You can afford to pay for a doctor visit if you get strep throat. But, can you really afford not to have any health insurance? If you have an accident— while driving or snowboarding, for example—or if you suffer a catastrophic illness, it could cost thousands or tens of thousands of dollars. It is smart to look at your health insurance options. Whether your employer offers health insurance or not, you should at least consider purchasing major medical coverage (that is, coverage for nonpreventive care).
Dental insurance: The cost to you is often small, so compare that cost with what you would pay for semiannual checkups.
Flexible spending accounts: A flexible spending account is a way for you to pay certain expenses with pretax dollars. It doesn’t make sense to incur higher costs by paying these same expenses with after tax dollars you receive in your paycheck.
Depending on the structure of the program, you may be able to pay for some or all of the following on a pretax basis: premiums for your employer sponsored health insurance (sometimes called a premium-only plan); medical expenses that are not covered by your insurance (such as deductibles, co-payments for doctor visits, contact lenses, a first-aid kit) through a health care reimbursement account, and child care through a dependent care reimbursement account.
Life insurance: This benefit is intended to provide income replacement if you die. If you are supporting only yourself, you may not need any life insurance, or only a small amount that would cover burial expenses. When you become a homeowner, you should consider life insurance to cover any expenses associated with the property until it can be sold. If anyone relies on you for financial support, life insurance provides a way to continue that support after your death. Many employers include a small amount of life insurance in their employee benefit packages.
Transportation fringe benefits: These programs allow you to pay for mass transit commuting expenses or certain types of parking on a pretax basis. Again, if you commute to work by train or bus, why incur higher costs by paying these expenses with after tax dollars?
Tuition reimbursement: This is a way to pursue an advanced degree related to your field. You make yourself more valuable to your employer and open up more career opportunities for yourself. You also could take courses to enhance the skills needed for your current position. Employers often structure reimbursement amounts based on the grade you receive in the course, paying pay more of the cost if you get a better grade to give you an incentive to work harder.
Putting it all together
Once you understand the benefits offered to you by your employer, you should look at your paycheck as one piece of your compensation. While it is likely to be the most important piece to you, don’t discount the other 30.2 percent. Your knowledgeable use of these benefits provides you with controls over your future financial security and your current expenses.