The Benefits of a 401k

With the future of Social Security up in the air and the almost complete non-existence of pensions in today’s workplace the options for retirement income continue to shrink. At the same time Americans are living longer and longer, the average 60-year-old American has a 50% chance of reaching age 92. A 92 year old has a 25% of reaching 100. At this rate by the time a 20 year old reaches age 60 the odds of living to 92 will be considerably higher. This means that the retirement years are becoming longer and longer. With the prospects of Social Security and a pension disappearing saving for this time is more important than ever.

If only there was a way to save for retirement, get a tax break, and make free money. It sounds like the ideal retirement plan. Fortunately it does exist, and it has become very common. It is a 401(k). Named after the section of the tax code that establishes this program the 401(k) could be the best idea that has ever come out of the IRS.

No one enjoys paying taxes. We all work hard for our money, the more of that we can keep the better. A 401(k) allows contributions to come out of your paycheck before taxes are withheld. This results in an immediate tax savings. It also means that your paycheck will decrease less than the amount of your contribution to your 401(k).

If that isn’t good enough your investment grows tax-deferred. Your money in that 401(k) will grow without you having to bear the burden of paying taxes on it until you draw those funds out. When you do, at retirement, your tax bracket will most likely be lower than when you invested the funds into your 401(k).

But, you say, I want to hear about that free money thing. I won’t keep you waiting any longer. Employers receive tax benefits by offering their employees a 401(k) plan. In order to encourage participation they often match contributions up to a certain percentage. Why do they do this? It’s cheaper than offering a pension.

Currently the average match is fifty cents to the dollar up to 6% of your income. What that means is that your employer will contribute to your plan half of what you contribute up to a maximum contribution (on your part) of 6%. It’s like getting a 3% pay increase that is applied to your retirement and grows tax deferred. This is literally free money that your employer is giving you. I’ve also never heard anyone say that they just wouldn’t want some extra money from their employer for free.

Employer’s 401(k) plans vary; these particular figures are the current average. I’ve heard of many employers that contribute dollar for dollar and some that contribute up to a certain percent at one rate and a lower percent beyond that rate up until a certain amount (for example, dollar for dollar on the first 3%, fifty cents to the dollar for the 4th and 5th percent, effectively adding 4% to your 5% investment).

For all of these wonderful benefits that accompany a 401(k) (you never thought you would thank the IRS for anything did you?) there are a few things to keep in mind:

* There is a federal limit to your annual contribution that has been increasing gradually. It is currently $15,500 for 2007. If you are older than 55 years your limit is $20,500. Your employer may further restrict your contributions to your 401(k) plan.

* If you are a “highly compensated employee” your legal contribution is limited further. A highly compensated employee means that you make in excess of $100,000 a year.

* Since the 401(k) is a retirement vehicle you are penalized for withdraws before age 59 and 1/2 in most cases. You will be required to pay the taxes on the withdraw and an additional 10% penalty to the IRS.

* A final point to remember is that when your employer gives you all that free money it is subject to a vesting schedule. That means that although they have contributed that money to your plan you must wait a certain amount of time before being able to control those funds, that is before you can take them out. Leave your employer before that vesting schedule comes due and you forfeit those funds.

If retirement savings, tax deferral and free money sound like a good idea to you then a 401(k) is a great option for you to consider. Carefully review your employer’s plan to make one of the best long-term retirement decisions that you can possibly make. You’ll thank me in 10-60 years.