Wise Investment Strategies Can Make You a Millionaire!by Bryan Carey
May 24, 2001 (Updated Jan 1, 2010)
The Bottom Line 401K plans offer many advantages that make them an essential part of anyone's investment portfolio. If your employer offers 401K, sign up asap!
With the prospects for receiving Social Security money in the future getting less and less likely every year, saving for retirement is more critical than ever before. To help people save for retirement, and prepare for the collapse of the Social Security pyramid scheme, we have several retirement savings plans to choose from, like IRA’s, Roth IRA’s, 403B, 401K, etc. Each of these plans has some investment restrictions, but they are all helpful and if they are properly utilized, they can help make one’s retirement more secure. These plans offer much more potential for wealth accumulation than a regular savings account.
401K plans are the most popular retirement investment vehicle. The majority of companies in the United States now offer 401K to their employees. Let’s take a look at some of the important advantages and disadvantages of 401K plans, compared to regular savings accounts.
How Does a 401K plan Work?:
With a 401K plan, money is withheld from your paycheck at a level (usually a percentage) determined by the employee. Typically, an employer will then add a matching amount to the employee’s money. This “match” can vary greatly. Some employers match dollar for dollar, others might match only 10% of the employee’s contribution, and some may not match at all. Whatever the match, you have to remember that it’s free money, given to you by your employer. This reason, alone, makes it worth your while to sign up for your company 401K plan.
The money that is withheld from your check is then combined with your company match, and invested in mutual funds that the employee chooses, or money- market, or company stock, or whatever other investment options that your particular 401K plan offers. Each person’s investment goals are different but, as a general rule, you should diversify your investments among many mutual funds, making sure that you place most of your money in growth- oriented funds, to get a higher return on your investments.
401K plans are all exempt from Federal tax, but not from Social Security or Medicare taxes. Most states also exempt 401K from state tax, too. If you have local tax, it will probably not be exempted. That’s because cities are usually very tight with their money, and they normally don’t allow any exemptions at all.
How are 401K Plans Better than a Savings Account?:
There are many reasons why 401K plans are better than a bank savings account. The most obvious reason is the tax- exempt feature that I mentioned earlier. Let’s say that I make $1,000 per week, and I am contemplating placing 10% of my pay in either 401K or in a regular savings account. Let’s also assume that my Federal tax bracket is 28%, and my state tax bracket is 5%. Since 401K is exempt from these two taxes, my $100 contribution (10% of 1,000 gross pay) will actually lower my net pay by only $67, not $100. That’s because 401K is taken off of your taxable gross amount, and the remaining money is taxed. So, even though I’m giving up only $67 in pay, I’m still saving $100, thanks to the decrease in taxes. With a regular savings account, I would be giving up the full $100 in net pay, because there is no tax- exempt feature.
Another advantage of 401K is that the returns are usually higher. The reason I say usually higher is because some people who are more risk- averse might choose to place all of their 401K money in a money market, which won’t return much more than a bank savings account. This isn’t advisable, of course, but many people who are less knowledgeable about investments might be tempted to put all of their money in money market, or some other safe, fixed- income type of investment. If you do this, you will miss out on the potential to make a large amount of money.
How much will you lose in the long run, with a savings account? Here’s an example: Let’s say I plan on contributing $250 per month, to either a 401K plan that returns an average of 14% annually, or to a savings account that returns 5% annually. My income (and therefore, my 401K contribution) is estimated to increase by 5% each year. I have 30 years until retirement. At the 14% rate of growth (investing in growth- oriented mutual funds) my investment will be worth $1,957,399.35 in 30 years. At the 5% rate of growth (investing in a bank savings account) my investment will be worth only $385,206.17 in 30 years. And, if you have even more years until retirement, the differences are even more dramatic. Using these same rates of return, and a 40 year time span instead of 30, the 14% investment would grow to $8,206,830.08 while the 5% investment will grow to only $841,282.81!
Yet another advantage, that some 401K plans offer, is the ability to borrow money from your plan, for purchasing a home, to consolidate bills, etc. If you choose to do this, it’s considered a loan and you have to pay it back with interest. But since you are borrowing from yourself, you are paying yourself the interest, making the loan, in effect, interest free.
Finally, another advantage of 401K plans is the company’s matching contribution. Even if your company has a small match, like 10% of the employee contribution, it’s still to your advantage to sign up with the 401K plan, because you would be getting an instant return of 10%.
Are There any Disadvantages With 401K?:
There are a few things about 401K plans that might make them unsuitable for some people, under unique circumstances. The main thing that you give up, with a 401K plan, is liquidity. With a regular savings account, you have unlimited access to your funds, and you can withdraw them at will, without incurring any penalty. With a 401K plan, you can borrow the funds, without paying any up- front penalty, but you have to pay the money back. If you want to withdraw some of your 401K money, and you have not reached age 59 ½, then you will likely be subject to a 10% penalty. There are a few exceptions to having to pay this penalty, like permanent disability, but most people will have to give up 10%, off the top, if they withdraw their 401K money.
Another possible disadvantage to 401K is that you could end up paying back more in taxes than the initial amount that of tax that you saved. As we all know, 401K plans are tax- exempt, when the money comes out of your check. But when you start to receive the money in the future, it becomes taxable. The whole idea behind a 401K plan is that in the future, when you start to make withdraws, you will most likely be in a lower tax bracket than you were when you were working. There’s a good chance that you will be in a zero tax bracket when you retire, which means you won’t pay any tax on your withdraws at all. However, if there is any remote possibility that your retirement tax bracket would be higher than your working tax bracket, then you may not want to invest in a 401K, because you would pay more tax in the future. Is this situation likely to occur? No, it isn’t. But it is possible, if you still have many taxable sources of income when you retire.
You should also keep in mind that 401K plans have limits on the amount of money that you can contribute. Right now, the Federal limit on employee contributions is $16,500 annually ($22,000 for those age 50 and up). This amount will likely increase in the future. Also, the Federal percentage limit on 401K (employee contribution plus employer match) is 25% of your total gross income. You cannot contribute any more than one- quarter of your total gross pay into a 401K plan, inclusive of your company matching contribution, even if your income is so low that you couldn’t possibly reach the $16,500 level. You are still restricted to 25% regardless.
With the Social Security system heading toward bankruptcy, it’s very important that each individual pay close attention to his/her retirement planning. Even if Social Security hangs on and survives for a few more years, the amount of money that you will receive per month will be far less than adequate. You will still need something to supplement the miniscule pittance of cash flow that Social Security will provide you. A savings account isn’t good enough. You need the higher returns that mutual funds provide, if you want to have a retirement nest egg that will make your golden years secure and happy.
401K plans are an excellent way to save more for retirement. The tax- exempt feature, along with the company match, should make the decision a no- brainer for most individuals. Like my example shows, a little discipline now can add up to millions of dollars for your future.