A 401k is an employer sponsored retirement savings account, where you can contribute monthly or biweekly, directly from your paycheck. The contribution could be before taxes or after taxes, depending on the type of plan you choose.
One major advantage of a 401k is that it allows for easy, consistent contributions, and many employers will match your contributions up to a certain limit.
There are two types of accounts:
- Traditional 401k (Tax deferred): This is the type of account where contributions are made before paying taxes. This can be an advantage if you estimate that your income/tax bracket will be lower, once retired, than at the time of making the contributions.
- Roth 401k: This is the type of account where contributions are made after paying taxes on on your paycheck. This is a good option because your money grows tax free, therefore you don’t have to pay taxes once you have retired and start collecting you hard earned money.
How does it work?
A 401k account lets you contribute a portion of each paycheck into your retirement account where you can invest in mutual funds, index funds and target date funds.
The fact that you can invest your hard earned money through this type of account is a major incentive, because you can benefit from compound interest and tax advantages.
Distributions prior to 59 1/2 years of age are subject to a 10% tax as an early distribution penalty, besides state, federal and local income taxes.
401K advantages:
A few key benefits of this type of accounts include:
- Employer contribution:
This is one of the main advantages for a 401k. Your employer might be also contributing to your retirement account. This is, the employer would match your contribution to a certain percentage.
The way to take advantage of the employees contribution is for you to contribute enough to your account so that you get your employer maximum contribution to your account. Think about it as free money or a salary raise.
- Automation:
The easiest way to save and invest is by doing it on autopilot, this way you don’t have to think about it and there is not opportunity for your to spend the money.
- Compounding:
Compounding makes time work in your favor. This happens when your investment earnings are added to your principal, forming a larger base on which earnings may accumulate, and as your investment gets larger, it grows faster, producing a snowball effect.
The possibility of your retirement savings/investments compounding over time makes a 401K account much more appealing, as the earlier you start investing, the larger the return you can expect.
- Tax advantages:
With traditional 401k you save part of your paycheck before state and federal taxes are withheld. Money contributed under this type of accounts lowers your taxable income, therefore you pay less taxes now. This doesn’t mean that you never pay taxes. You will pay taxes after retirement, at the time of withdrawing your contributions and earnings. Usually retirees are at a lower tax bracket than when they were employees.
With a Roth 401k you pay taxes before making contributions from you paycheck, but after this the money grows tax free, and if you wait until retiring and to be 59 1/2 years of age before you start collecting, you will not pay taxes at the time of withdrawing your earnings and contributions. Sounds good, right?