You've undoubtedly heard financial professionals sing the virtues of 401(k)s. However, if the only feature you associate with the retirement saving plan is its tax advantages, you may be missing out. Beyond the money you can save, thanks to the pre-tax nature of most 401(k)s, there are plenty of other ways a 401(k) plan can benefit you. Here are four of them.
1. Compounding works in your favor
Have you ever noticed how difficult it can be to pay off a high-interest loan or credit card? That's due to compound interest working in favor of the lender. With compound interest, you pay interest on the principal borrowed and on interest previously added to your debt.
For example, if you have a credit card balance of $5,000 and make a $200 payment toward it instead of paying it off in full, interest charges are added to the remaining $4,800. The following month, you're charged interest on the remaining $4,800, plus the added interest from the previous month.
When you invest in a 401(k), compounding works in your favor. Rather than pay interest, you earn an investment return on the money contributed. Better yet, the money you earn stays invested in your account so that you earn further returns on both your contributions and any accumulated returns from previous months.
Compounding in your 401(k) can significantly boost your returns.
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2. Your employer may offer you "free money"
When was the last time someone offered you free money? 401(k) plans allow employers to contribute to your plan, and the gift can add up. While employer matching is not mandatory, many employers offer it to attract and retain employees. These matches are typically based on a percentage of your salary.
An employer can plump up your 401(k) in three ways:
- Partial match: With a partial match, employers contribute a percentage of what you contribute. One common way of doing that is with a 50% match, up to a set amount.
Let's say your employer offers a 50% match up to 6% of your salary, and you earn $60,000 annually. If you contribute 6% of your salary, your total contribution is $3,600. However, since your employer matches 50% of your contribution, an extra $1,800 (50% of $3,600) goes into your 401(k). - Full match: A full match is also called a "dollar-for-dollar" match and means the employer will match 100% of your 401(k) contributions, up to a limit.
Using the same illustration, let's say you contribute 6% of your $60,000 annual salary, and your company's policy is to match 100% of your contributions up to 6%. That means you put $3,600 into the account over the year, and your company contributes another $3,600. - Nonmatching contributions: Also called "nonelective contributions," these are less common than partial or full matches, but involve the employer making contributions to your 401(k) even if you don't contribute. If you do contribute, your employer may even match (partially or fully) your contribution and still make a nonmatching contribution.
3. You don't have to pick individual stocks
If you're new to investing or not yet the world's most confident investor, contributing to a 401(k) means having access to a broad menu of investment options managed by professional money managers. As the investment options in your 401(k) are typically professionally managed by someone else, you can focus on picking the best ones available, and then have time to learn more about how investing works and to become confident enough to manage other investment types.
4. 401(k)s offer some creditor protection
Under the Employee Retirement Income Security Act (ERISA), your 401(k) funds are typically protected from creditors and bankruptcy. While traditional and Roth IRAs and some 403(b) plans are not protected under ERISA, you can feel confident knowing money in your 401(k) is safe from creditors.
The exception to this rule is if there's a court order related to a divorce or child support ruling or another civil judgment. The government can also seize money from your 401(k) to cover delinquent federal taxes or pay criminal penalties.
If you don't have any judgments against you, the good news is that there's generally no cap on how much money in your 401(k) is protected. Whether you have $5,000 or $5 million, creditors can't get to it.
But the benefits of a 401(k) don't stop with these four features. For example, if you struggle with spending, contributing to a 401(k) automatically makes your investments for you, bypassing the temptation to spend the money. A 401(k) is also something you can slowly grow into by adding a little more to your contributions each year. Finally, if you change jobs, the money you've contributed and its earnings still belong to you. You get to decide if you want to move it somewhere else.
While every investment involves risks and potential rewards, there are few plans like a 401(k) for systematic wealth building.
