For most workers out there, employers have on offer a retirement plan. In the past, this used to be in the form of a pension plan guaranteed by the company. But with a lot of companies moving away from this corporate financial liability, the in vogue benefit offered to employees has become the 401(k). So how exactly is a 401(k) beneficial in establishing a retirement strategy?
Depending on the employer, the 401(k) plan gives you a variety of mutual funds to invest in set by the company managing the accounts. Some of your wages are set aside pre-tax and placed into the 401(k) account and you choose how much of that contribution are placed into which mutual funds. In addition to the untaxed money, there also tends to be a matching contribution from your employer. The match is commonly 50% of your contribution up to a certain percentage of your wages. So if you set aside 8% of your wages, your company will kick in an additional 4% to give you a total of 12% of your wages set aside in a retirement account.
Why is this so great you might be wondering. Couldn’t you just set aside the money yourself and invest it in whatever you feel like? Yes, you very well could, but then you will have to give the tax man his cut. And if you’ve read the compounding interest article you should know that taxes eating away at your gains will reduce your potential overall savings by a lot in the long run. When you put money into your 401(K), you get that percentage of your wages without it having been taxed and it reduces your taxable income by the amount you set aside. If done properly, you could potentially keep yourself in a lower tax bracket, saving yourself even more money.
While the tax benefit is by itself a great reason to put money into a 401(K), there are also a few other advantages. First, you set up an amount to be automatically deducted from your paycheck. There’s no easier way to save money than to not have it in your hands to spend in the first place. Second, if you’re in a bind you can take out a loan on the balance of your 401(K) or even make an early withdrawal without penalties if under specific hardship situations. Third, you can rollover your 401(K) to another company if you decide to change careers.
But you still need to be careful and keep track of this investment tool. At least once a year you should re-balance the distribution of mutual funds you choose to invest in to keep your money thoroughly diversified. Another issue to be aware of is the fees the mutual funds incur since those will also eat into your long-term earnings. If you change jobs often or have a major financial emergency, be cautious when handling your 401(K) since you might incur penalties and taxes if you don’t follow the rules for withdrawal or rollover.
There are limitations to the amount you can contribute to the 401(K), but you can contribute more if you are 50 or older. After 59 1/2 you can begin withdrawing money from your 401(K) without penalties and you must begin taking distributions after you reach 70 1/2 unless you are still working. Since the 401(K) is a tax-deferred account, you don’t pay any taxes on the gains of the account, but you pay taxes on the distributions you take when you start withdrawing money. A 401(K) is best if you expect to be in a lower tax bracket in the future since the money you put in will then be taxed at a lower rate than if you hadn’t put it into the 401(K).