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401(k) Step 1: The Birds 'n' Bees of Your 401(k)

Here's virtually everything you need to know about a 401(k) plan:

  1. It's one of the very best ways to save for your retirement. Few alternatives are better.
  2. There's a chance that your employer will give you money for participating in the company plan.
  3. You should start contributing to your retirement plan as soon as possible.
  4. If you are more than 10 years away from retirement, you'd probably fare best by putting most of the money that you defer into an equity index fund. A so-called target retirement fund is also a good choice.

You may need to read no further than this. Seriously.

We wanted to get all the information we could to you right up front because this stuff is pretty important. Studies show that if you're the average Internet reader, your attention span is so limited that you've probably already clicked over to some other website by now, although the big bright words in red at the bottom of your screen just might have kept your attention. Ha! Got you to look!

Therefore, in an ongoing effort to keep your fingers from tapping out www.gotta-be-more-interesting-than-401(k), we'll try to keep things moving -- beginning with mentioning again that there could be free money involved. Hey, we're not going to be dispensing any free money around here, but your boss just may be. If you can get some of that, various other studies show that you'll be happy you stuck around here for a couple hundred words.

To begin at the beginning, in 1978, section 401(k) of the Internal Revenue Code authorized the use of a new type of deferred compensation retirement savings plan for the benefit of employees of most private firms. Employees who participate in employer-sponsored 401(k) plans choose to defer part of their salary, and the employees themselves determine how much of their salary to defer and how to invest the money.

Participating employees choose to take home a smaller paycheck because there are several major advantages to saving for retirement through a traditional 401(k), including:

  • Immediate tax savings on contributions
  • Tax-deferral of any investment earnings
  • In-service loans and withdrawals
  • Free money

Those first two or three might not have looked quite so interesting, but the free money item is an eye-catcher, ain't it? Before we get to that (we're saving the best for last) let's go over the first three, because they aren't so bad either.

When you defer compensation into a traditional 401(k), you immediately start paying less to Uncle Sam. The amount that you decide to defer is money that comes out of your paycheck before income taxes come out of it, and the money goes right into an account with your name on it. That's money that you're keeping out of the hands of the federal and state governments until you retire. (And, hey, you may decide to retire in some state where there are no income taxes.)

Just as important, because the taxes on the investment earnings are also deferred, you're not paying any taxes on anything that your deferred compensation earns until years from now when you're retired.

Does it get any better than that? Perhaps. Some investors might benefit more from the Roth 401(k), a relatively recent development. As with the Roth IRA, the tax benefits are backloaded; contributions don't reduce your taxable income today, but withdrawals are completely tax-free, if you follow all the rules. To learn about the Roth 401(k), read this article.

Another feature of some 401(k) plans is that Fools can lend back to ourselves some of the money that has been deferred for something important like buying a house or meeting expenses should an emergency arise. This is money that we can borrow from ourselves, rather than from a bank.

Fools, though, will borrow from a 401(k) plan only as a last resort. That's because we may change jobs before the loan is repaid. If we do, that loan is immediately payable with interest. Fail to come up with the necessary cash for that repayment, and there's a stiff price to be paid. Uncle Sammy will call the unpaid debt a "deemed distribution" from the 401(k). It will be taxed and -- assuming we're younger than age 59 1/2 -- penalized 10% as well for an early withdrawal of the money. Additionally, the interest we pay ourselves on the loan comes from money on which we've already paid taxes. But for 401(k) purposes, it will count as untaxed earnings. That means we will pay taxes on that money again in retirement when we make withdrawals from the 401(k). Bummer on both counts! Thus, while the loan feature is attractive to some, Fools think it's really something to use only when all else fails.

The best reason of all to contribute to a 401(k) or other deferred compensation plan is that many employers match a portion of the money deferred by their employees. That's right -- these employers are giving away money. Woo-hoo! Find out about whether your employer is providing matching contributions. If it is, you absolutely should commit yourself to deferring every dollar you can up to the amount that your employer is willing to match. How big a difference can employer matching make? Well, if your employer is matching your contributions dollar for dollar, you'll be, of course, doubling the amount of money put away for your retirement.

Save early and often
Need another nudge to sign up for your 401(k)? Then consider the following chart:

As you can tell, you really can't start too early. The number of years that your investment will be compounding is a huge part of saving for your retirement, but it's not the only part. Making sure that the money is invested properly is also important. And that's exactly the subject behind door No. 2.

Read/Post Comments (5) | Recommend This Article (73)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 10, 2009, at 2:45 PM, schmozini wrote:

    Thanks, for the heads up. I have been in a 401k since the git go and believe I have a bulett proof john Hancock portfolio. However, I am a newby to investing and rely on almost at times accidental luck . i am 60years old ...have a 100,35000 in cash but am not very knowledgeable in exactly how the markets work or why they work. I have come to you wise fools for advise.What is my best move besides getting a better financial awareness. Thanks, schmozini

  • Report this Comment On June 16, 2009, at 11:13 AM, jen8888 wrote:

    while the tax benefits of the 401k are great, what's not great is that you have to invest that money in securities and can't diversify with alternative assets. this is another article "selling" us one benefit of the 401k, but not telling us the downside in the same breath. the solo 401k is better in that it frees your assets to invest outside of wall street and you still get the huge tax benefits without gambling in the stock market. check out the IRA Association of America - has good info on this.

  • Report this Comment On June 16, 2009, at 11:40 AM, FreeTruth wrote:

    Every eligible American should have a fully funded ROTH IRA while you can still get one. The opportunity to invest money now and then access it later sans capital gains tax is incredible. I am not a big fan of 401K's (though I do have one), as typical mutual fund choices are limited within the 401K and the option to access your money is quite limited. Plus, I do not believe that the majority of folks understand the tax implecations of these vehicles. As an example, schmozini, I don't know a thing about you, but I would willing to offer a guess that at 60 years old, you are probably in the highest tax bracket you personally have ever been in. Depending on when you retire and when you access the funds in your bullet proof 401K, you could be heavily taxed on your capital gains. What you think you have, you really do not. You're probably well on top of these sorts of things, I just use it as an example of where the vast majority of people probably are. Finally, you've heard of those books about the automatic millionaire and to put your investing on auto-pilot, etc. With 401K's, this is what people end up doing and while I would agree that most people do not have the ability to save consistently month over month, when you are on investment auto-pilot, you tend to offer only fleeting glances at your money and rarely make changes or corrections. Sticking with the airplane metaphore, if the finanical meltdown last fall was a mountain, the reason why most people hit the mountain is because they were on auto-pilot and were not making changes or adjustments that were needed to fly around.

    I believe you will see this ROTH IRA retirement investment option removed in the future. The taxes on the capital gains will be too hard for a cash strapped government to ignore and they will grab for them.

  • Report this Comment On October 10, 2009, at 11:25 PM, BordLyron wrote:

    Capital gains, equity growth, even fixed-rate investments, my question FreeTruth, is what difference does any of this make in eventual tax implications if it happens in a TIRA or a ROTH IRA (as opposed to a taxable account)? I'm two beers into this reading, so perhaps my thinking is faulty. Please explain.


  • Report this Comment On November 19, 2009, at 10:29 AM, AbideN wrote:

    After college for 2 children, marriage for one daughter, we were able to significantly put money away at age 45 (now 50) I understand the max pre tax contribution is 22,000 is that correct? We are doing that with employer match for a percentage of that. It is hard to know when retirement date will be to choose one of the investment plans. Would you say 10 years is good? And if we retire earlier than that it will all be well? Also we both have separate 401k's not with the work program, can we contribute to those too? How does this all work? where can I find answers on tax reprecussions etc. HELP :)


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