Unlock the Power of the 401k

Who: This post is for folks who have a 401k plan, but don’t use it for some reason or another.
What: This post will discuss, in detail, many facets of a 401k plan and what it means for you. I will discuss basic principles of a 401k as well as pros and cons.

First, I will start my story of free money with some history. Back in the days of the horse and carriage, many companies gave their employees a Pension benefit. I won’t go into the details of pensions and the mathematics behind them because to be honest, I don’t really understand the mathematics behind them. The basic idea is that the employer would withhold an amount from the employee’s paycheck and that amount would contribute to the employee’s pension. At retirement, the employee could then theoretically live off the pension money. Pensions are a defined distribution retirement plan because the contributions aren’t controlled, but the distributions of the funds are somewhat fixed. That is just an example of one of many types of pensions. For a more in depth view of pensions, check out my favorite site.

Many companies owe huge amounts of money for pensions and more and more of them are now offering 401k plans instead. What’s this? You have heard of a 401k plan? In fact, you HAVE one, but don’t contribute to it? One word: lame. 401k plans allow employees to withhold money from their paychecks in a way they see fit (with exceptions and limitations of course). These monies (I like that word for some reason) are put into 401k investment accounts in which employees have various options for investing the money.The problem is that many people do not contribute to their 401k plans. Many people don’t know what it is. Other people might know what it is, but don’t understand it’s benefits. Finally, there are people who know what it is and understand it, but don’t contribute because they cannot afford to put money towards the 401k. So without further ado, I’ll discuss how the 401k works, as well as the pros and cons of a 401k plan. (For the purposes of this introductory post, I will not discuss the Roth 401k).

How It Works:

The employee (you) will elect to have a certain percentage of his/her salary put into the 401k plan. This percentage will be deducted from each of your paychecks. This money will be put into the 401k account. This money can be used buy purchase mutual funds or other securities (they vary from plan to plan). Basically, you are automatically deducting money from each of your paychecks, to invest them in securities, so you can draw from the funds in retirement.

Why the hell do I want to do this? (This is a very good question)

1) First, you do not get taxed (immediately) on the funds that you defer to your 401k plan. Yes, you heard me correctly, no immediate taxes. If your total income is $60,000 and you defer 10% of your salary to your 401k, you will only be taxed on $54,000. That’s tax deferred growth, and it is a powerful thing.

2) Free Money. Yes, Free. Free as in Beer. Many companies offer a “company match” in which companies reward you for contributing to your 401k. These offers vary from company to company, but some popular ones are a “100% match for first 3%” or “50% match for first 6%”. This means that the company will match every dollar you put into your 401k, up to 3% of your salary or 50% of the first 6% of your salary that you contribute, respectively. In all honesty, there is no catch here. It is free money. You put in some money, your company will put that money in too. It’s yours to keep (provided it gets vested, but I’ll talk about that later.)

3) You are saving for retirement. It is almost a foregone conclusion that social security income is not sufficient to sustain you during retirement. You will need to start saving sometime. Starting early is beneficial because compound interest (there will be a post on this too) is a great thing.

The Cons:

1) You don’t completely escape taxes. You are taxed on the money that you take out during retirement, based on your tax bracket at that time. This means that if you’re in a lower tax bracket at retirement, you’re paying a lower tax rate on the money than you would have if you were paying the taxes when you earned them (back in the olden days when you were young, strong, and earning lots of money).

2) The free money you get isn’t always yours immediately. While the money that you put in is always yours, if your company has a “vesting schedule,” then you may have to wait awhile before the money that the company contributes is yours. For example, many companies have a 4 year “graded” vesting schedule. This means, that over the course of 4 years, you are entitled to portions of the money that COMPANY has paid into your 401k. 25% after 1 year, 50% after 2 years, 75% after 3 years, and finally, the entire amount after 4 years. The money is still free, you just need to wait for it.

3) You shouldn’t touch it before retirement. The money is yours after all, so you can withdraw it, but not without paying taxes and heavy penalties on the amount. This is somewhat restrictive, but in the end the benefits of saving for your future far outweigh the negatives.

Hey Dumbass, There are The Same Number of Pros as Cons

I would like to thank the readers for astutely pointing this out. If you read carefully, you can see that the cons are actually not really that bad at all. You have to wait until retirement to touch your money, which is the point of saving anyway. Additionally, you still get free money, you just need to wait a few years before you have the right to withdraw it.

Ultimately, there are very few investments better than investing in your 401k plan in full, up to the amount your employer matches. Even beyond the match, a 401k is a great place to park your additional income to save for retirement because of it’s tax advantaged status. If you think that you will be in a lower income bracket during your retirement (either because you won’t work, or you think income taxes will decrease) then putting money in a 401k NOW will save you from having to pay taxes at your higher (current) rate and instead, you can pay taxes at a lower (in the future) rate.

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