Define: 401(k) Retirement Plan
Three numbers and a letter – which, if you pay attention, sum up to free money. If you don’t pay attention, you could be leaving part of your compensation on the table. And let’s face it; employers aren’t going to thank you for doing so, either. These four characters are so important that we’re switching the order of the article – usually we try to say what something is, and then make suggestions on what to do.
Here, you can feel free to collect your $200 and go directly to the bank.At the bank, or actually through the banks or brokerage houses chosen by your employer, our suggestion is to put that 401(K) money in some sort of equity index fund as soon as possible. This should be done at the same speed as when you found your DVF dress across the room at that crowded sample sale.
“Equities always outperform debt investments over 15, 20, 30-year time horizons,” says Jason Drill, an investment and financial services expert (and new contributor to Prosperity!). Making an equity index just the ticket for the young and young(ish).
As you get closer to retirement, you’re going to want to make sure that your portfolio is spread across a diverse group of securities – for more on that check out portfolios, assets and diversification in The Basics.
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And now back to our regularly scheduled article. These retirement plans are named after section 401(k) of the Internal Revenue Code, which created an elective deferred compensation retirement savings plan for employees of most private firms. Eligible employees willingly defer part of their salary into an invested account, rather than putting it in their pocket, and employers may match a certain percentage of the investment. You can choice how much of your salary to invest, up to $15,500 per year.
So why choose a smaller take home now? Because of the many huge advantages to towards your retirement savings, like:
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Immediate Tax Savings - Deferring part of your salary into a 401(k) means that while you get less at the end of a pay period, so does Uncle Sam. Money goes into a 401(k) before income taxes are assessed on your paycheck. The federal and state governments don’t look at this money until you make withdrawals, usually when you retire. So less money equals more money, because when you retire, you may be taxed at a lower income level, reducing the fees assessed on your savings as taxes.
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Investment Earnings Are Tax Deferred – Not only do you not pay tax on the money going into the account, you don’t pay taxes on the money that money earns (compound, baby) until your retirement.
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In-service Loans and Withdrawals – Ok, this is a benefit like having hospitalization being covered under your insurance is a benefit. It’s not necessarily something you ever want to use, but in situations like buying a house or emergency expenses, you may need to lend yourself back some of this nest egg. There are all sorts of stipulations that come with doing this; not meeting them could result in taxation and a 10 percent penalty, all due to Uncle. So you’ll be paying taxes twice on the same money (now, and then when you retire).
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Free Money – Our favorite four letter word, Free. Your employer may match a portion of the money you put towards your 401(k). So if you can, put away up to the amount where your employer caps matching. That makes everything you deposit a twofer. All that much more to feel the power of, lets all say it together, compounding.
By putting this money away now, your charm, brains and good looks aren’t the only things working for you; you’re working the power of accrued interest until you retire.