What is a 401(k)?
A 401(k) retirement plan is a great way to save money. 401(k) plans are best-suited for younger investors that will be looking at the 401(k) plan as a long-term investment. Employers normally offer some type of retirement package to attract new employees. In the past the employer would be able to contribute 3 percent or more to your retirement. With the current economy, several employers have cut back on the contributions because they simply cannot afford to continue investing. 401(k) plans come with some great tax benefits and the employees are able to select a portion of their salary to go straight to the 401(k). This way, the money is deposited in your 401(k) before you even see it. This is known as a salary deferral plan.
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A salary deferral plan means you are in charge of deciding how to invest the money that is being accumulated in your retirement account. A retirement plan will include a list of several investments you can choose from. Several people like 401(k)'s because they are able to choose which investments will help them meet their retirement goals. The list of investments may not be as good as the investments you can get when you invest with a broker or independently, but they will still produce a decent return.
The money your employer reports to the IRS is reduced by the amount of money that is deferred to your account; this means the income taxes are withheld on this money until you withdraw from the account. So in essence, the money in this account is tax-free until you need to withdraw it. This can be a nice advantage, but it can also be a disadvantage too. Since you don't know what the stock markets will look like when you reach 59 ½ years old, you have no way to predict how much money you will end up paying in taxes to get out the money you invested.
If you don't want to pay for taxes when you withdraw the money in the future, invest in a Roth 401(k). With a Roth 401(k) the amount that is deferred doesn't reduce your current income taxes or your taxable income. The money you withdraw later in life is 100 percent tax free. You must be at least 59 ½ years old and the Roth 401(k) must be open for at least 5 years in order to withdraw from the account. Since the money is being vested in the account, any earnings your tax-deferred contributions make will remain tax-deferred, allowing the amount to compound at a faster rate. This is a better investment decision since you need to calculate inflation and all the other costs that will be around in the future.
When you contribute to a salary deferral 401(k) plan, the money belongs to you. You will not have any legal rights to the money contributed by your employer until you are fully vested. Vesting will be determined by the amount of time you spend with the company. The 401(k) plans will differ with each employer. Publicly held corporations tend to offer 401(k) plans while nonprofit organizations typically offer 403(b) plans. You can move your retirement plan with you if you change jobs, but some of the rules and guidelines may change.
Once you retire, you can start withdrawing money from your 401(k), the tax you pay will be determined by the income tax rate at the time of the withdrawal. Since there is no way to predict what tax bracket you will be in when you retire, you should plan on having a smaller income for retirement than you had when you were working.
