Section III-A - Lesson 1
Your 401k - Its Awesome Power
Simply stated, the purpose of your retirement account, whether it’s a 401k or an IRA, is to take advantage of available tax benefits while saving for retirement. Let’s face it! Were it not for the tax benefits, and the company match in the case of a 401k, we’d be better off directing all of our savings to our regular money account where we can access our money any time we need it.
But the tax benefits and the company match, if you have one, give the 401k an awesome power that cannot be matched by any other investment and make it literally irresistible. Let's look at these benefits.
First of all, your contribution goes into the plan pre-tax, which means you have not been charged taxes on the portion of your salary that you direct to your 401k. This equates your 401k contribution to the tax treatment you would receive with an IRA contribution, where you get to deduct this contribution from gross income for the year that you make it. Actually, the 401k contribution is an even better deal because the laws allow you to contribute a good bit more, on this pre-tax basis, than do the IRA rules.
Not only does your own contribution go into the plan pre-tax, but also the company’s matching contribution, if they make one. This means that the company’s match is not just free money, but tax-deferred free money. All of this adds muscle, or clout, to your own contribution.
On top of all the other tax benefits, everything in your 401k or IRA grows tax deferred until you take it out. Your own contribution, the company match, the dividends, interest, and capital gains distributions—everything grows tax deferred for however long you leave it in.
You are charged taxes only on money you take out of the account, and only if and when you take it out. Since no taxes have ever been paid on any of this money, you will pretty much pay ordinary income rates on everything you later withdraw from your retirement account. It may be 30 years or so, however, before you even start to take out money, and since you’ll only be withdrawing about 6% of your accumulated balance every year, the bulk of the taxes on this account may end up as the responsibility of your heirs.
The tax advantages, alone, of 401k’s make them extremely desirable as investment vehicles, but when combined with a company match, they are awesome! As previously mentioned, matching contributions run the gamut from one company plan to another, from 0% to 100%, with the typical arrangement being 50% of the employee’s contribution to a company limit of 3% of salary.
Can you imagine being able to earn an immediate 50% on all of the new money that you invest every year, up to a maximum of 6% of salary? You hand your boss $3000 and he hands you back $4500. Hand him $6000 and he hands you back $9000. This is essentially what is happening, and there is no phenomenon in the business world or the investment world that can equal it!
While it’s true that there are usually restrictions on this money in the form of vesting periods and how soon you can take the money out, and with what tax consequences, the fact remains that even an immediate 25% increase on your money is fantastic. We have got to go for this kind of deal, which is why we will urge you in Lesson 3 to commit to whatever it takes to capture the maximum match.
The big disadvantage, of course, to the 401k account, is the restriction on when and how to get our money out. Uncle Sam provides his tax benefits because he wants us to leave our money alone. Our employer provides his company match and vesting schedule because he wants to keep us around for a while. Nobody wants to let us have easy access to our 401k money, and this is the price we have to pay for getting all the benefits.
A Publication of About Your 401k.com
The book that inspired the birth of this website. Now available in either PDF or hardcover. Check it out!
_________________
_________________
_________________
