How To Thumb Your Nose at the TaxmanMay 17 '01 Write an essay on this topic.
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The Bottom Line A great way to save for a very rainy day, or a very bright retirement.
Does your employer offer a 401(k) plan at work? If they do, do you take advantage of it? You should. The 401(k) plan is an excellent way not only to save money for your retirement or future unexpected needs, but it’s also a way to reduce your current taxable income and defer it to a later date at which time theoretically your total income will be lower and therefore taxable amounts and rates will be less. What is it? The 401(k) is a retirement-savings plan offered through your employer via payroll deduction. It is in essence a forced savings, since you will not have general access to the funds in your account. Generally, you will select a fixed percentage of your pay to be contributed to the plan each pay period, usually one to 15 percent. One of the main advantages to the plan is employer matching. This means that most employers will offer a match of 50 cents to a dollar for every dollar you put in the plan, usually up to a certain percentage. Think about this. Let’s say your employer offers a 50-cent per dollar match on up to 6 percent of your pay placed in the plan. That’s an immediate return on your money of 50 percent, which is pretty hard to beat. Again, some employers even go higher in their matching amounts, so you may receive an even better return on your investment. One important term to understand with your 401(k) is vesting. Your employer will usually require that you have a minimum amount of time with the company before you are vested in the matching funds. This simply means you have to be employed with the company a certain number of years, often five or so, before that money the company contributes is yours. You’re always vested in your own contributions, and you don’t have to wait until you have satisfied the vesting period to begin contributing. The plan is portable. Should you change jobs, you can roll the amount in your 401(k) over into either an IRA account or a new 401(k) with your new employer. Who’s it For? In my opinion this is a great plan for everyone. It’s never too early to start saving for retirement, nor is it ever too late. Even if you can only afford to save one percent of your pay, that’s a start. Again though I’ll stress that the money you contribute to the plan is not readily available to you, so be cautious in how much you contribute. Don’t jump in above your head; you can only usually change your contribution amount on a quarterly basis. A great strategy to follow is to start out contributing 1 or 2 percent of your pay and then gradually raising that amount quarter by quarter. Just got a three percent raise? Put one percent of it in your 401(k). Think of your contributions as taxes that are out of sight and out of mind (though it’s tax you’re paying to yourself). Where Does It Go? Your contributions and company matches will be invested for further return. You will usually have a choice of investment options, usually a fixed rate fund, mutual fund, company stock, etc. You can sometimes even allocate portions of your money between investment options to minimize risk. 401(k) vs. Savings Account The 401(k) is a great plan to have in addition to a saving account. It should not replace your savings account. Keep in mind that you may need funds in a hurry for unexpected emergencies, and the 401(k) is not suitable for this purpose. Though you can obtain loans and hardship withdrawals from the plan, these processes take time. A savings account, therefore, has the advantage of liquidity over the 401(k). The 401(k), however, offers greater return and tax benefits (which we’ll discuss next). The fact that the funds are not easily obtainable also makes it easier to save sometimes. You’re less likely to blow your savings on that big screen TV you’ve been wanting if you have to go through a long drawn out procedure to get the money to do it. Taxes! The funds you contribute to your 401(k) are taxed when you take them out, not when you contribute them. This is a great way to reduce your current tax burden. Company match and any interest or dividends don’t get taxed until withdrawal either. The advantage of this? Your income at retirement will probably lower than while you’re working, so your tax rate will probably be lower too. You get to keep more of your hard-earned money, and everybody (except Uncle Sam) likes that. Should you ever become unemployed, you’ll have something to fall back on. You will pay a 10 percent penalty on withdrawals (in addition to the income being taxable) made before you turn 59 and ½ years of age, but again, should you become unemployed and exhaust your unemployment benefits, chances are your income will be lower and your taxes will be less even after the penalty. Conclusion The 401(k) is a great way to save for retirement and hardship. However much you contribute, it’s a step in the direction of financial independence in your retirement years.  |
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