A 401(k) is an increasingly popular investment vehicle available to many employees. Named after the section of the Internal Revenue Code that gives it full force and effect, the 401(k) plan was created as an extra incentive to save for retirement that eases the tax burden for those who participate.
The plan is an example of what is formally known as a “defined contribution” plan, a program set up and administered by an employer for employees. Taking advantage of your employer’s 401(k) plan can mean more money in your pocket and a more satisfying retirement.
Here are some of the benefits of contributing to a 401(k):
1. It enables you to save on your income tax. It has been said that “taxes deferred are taxes saved,” and a 401(k) can mean thousands of dollars in your pocket that would have otherwise gone to the taxman. The contribution from your paycheck is made before taxes are withheld, thus reducing your taxable income. You don’t pay taxes on the money until it is withdrawn from your 401(k), presumably once you’ve retired and have a substantially reduced level of taxable income and thus a lower tax rate as well.
2. Employers may match your contribution. Many companies will match your contribution in full or in part, essentially providing you with free money. Employees who sign on can contribute up to $15,000 a year (for 2006), typically drawn directly from their paycheck. “Catch-up” provisions enable employees over 50 years of age to contribute more.
3. The plan is portable and versatile. Contrary to a common misperception, you don’t have to work for a big company to participate in a 401(k). The vehicle is available to those in many smaller companies, and you can even set one up within a sole-proprietorship business. Also, your 401(k) holdings are portable. If you change jobs, you can roll the assets into your new employer’s 401(k) plan, or other types of retirement vehicles.
4. You get a choice of investment products. Generally, 401(k) plans are administered by reputable third-party financial institutions and banks. They tend to offer more conservative investment products, although more aggressive vehicles are also available depending on your risk tolerance. Plans are vetted by the IRS as well, meaning that it’s unlikely your investments or deductions will be disallowed down the road.
5. You will be forced to save. A 401(k) is often called a forced savings plan because the money is usually taken from your paycheck before you ever get your hands on it. By diverting even a modest sum on a regular basis, you can build substantial wealth over the long term. There are a number of 401(k) calculators available online to help you work out how much you can potentially save, how compound interest works in your favor and how much you’ll save on taxes.
While there are many advantages to contributing to a 401(k), it’s wise not to withdraw the money you contribute prematurely. Depending on your age and circumstances, withdrawing money prior to your retirement could trigger penalties that all but obliterate the benefits of contributing in the first place. Plus, by taking the money out, your savings are not growing.
As with any investment, you should consult a financial advisor to see if a 401(k) plan makes sense for you. An advisor can also help you determine an appropriate contribution amount, suggest suitable investment vehicles within the plan and help you decide how your plan should evolve over time, depending on where you are within your earnings and withdrawal cycle.
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