Updated on 6/02/2016
Here's virtually everything you need to know about a 401(k) plan:
- It's one of the very best ways to save for your retirement. Few alternatives are better.
- There's a chance that your employer will give you money for participating in the company plan.
- You should start contributing to your retirement plan as soon as possible.
- 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.
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.