Wednesday, March 08, 2006

Saving for retirement with a 401K

Saving for retirement is an important thing to get started on early in life. Most companies do not offer a pension any more so you are usually on your own when saving for retirement. Don't hold your breath waiting for social security either it probably won't do most of any good 20 years from now. Below you will find tips on saving for retirement and the advantages of saving for retirement by using your companies 401K plan.

History of the 401K plan: In 1978, Congress amended the Internal Revenue Code to add section 401(k). Originally the 401k plan was intended for executives, however it proved popular with workers at all levels because it had higher yearly contribution limits than the Individual Retirement Account (IRA); it usually came with a company match, and provided greater flexibility in some ways than the (IRA), often providing loans and an employer stock option.

Why should you save in a 401K plan: There are several advantages to saving in a 401K plan. The top three reasons are

  1. Matching funds: Most employers will provide a certain level of matching funds based on your level of investment into your 401K plan. For example if you contribute 6% of your income to the plan your company may match your contribution by 50%. Therefore if you make $50,000 per year and you contribute 6% or $3000 your company would contribute $1500 dollars. This is an immediate return of 50% on your investment, thats truely amazing. Just wait though it gets even better when you consider the tax benefits of contributing. Note: I recommend that even if your employer only matches a certain percent of your contribution if you can I would try to max out your contributions, the current limit for most people is a max of $14,000 per year so remember don't just contribute the 6% if that is all your employer will match.
  2. Reducing your taxable income: The contributions that you make to the 401K plan are tax efficient and provide most people with there best deduction to lower there federal and state takes. Lets take the same example that we did above, suppose you contributed $3000 and your tax rate is 28% on federal tax. By contributing this amount you will effectively lower your taxable income from $50,000 to $47,000 which lowers the amount of federal taxes that you need to pay during the year. So 28% times $3000 is $840 dollars in tax savings. Therefore when you add in the employer match of $1500 to the take savings of $840 the total return in the first year on your $3000 contribution is 78%. This return is a 1 time event for this year. However, 78% is pretty amazing.
  3. Tax efficient savings: The investment returns on your 401k plan will grow tax free until they with drawn during retirement. This means that is your investments in the plan are successful they will grown and compound for years without being tax. So for example if we add the numbers above the $3000 you contribute and the $1500 match from your employer you have $4500. Lets say you pick some good mutual funds in the 401K plan and you have a first year return of 10%. Which is $450 dollars, if you earned this amount in a bank account you would be tax on the $450, however in the 401K plan it grows tax free. Pretty cool.

Related posts:

If you enjoyed this post please Subscribe to Strategies for Life

No comments: