Some kind of tax return form or what?
A 401(k) plan is a retirement plan where your employer deducts a set amount or percentage from your (pre-tax) paycheck and puts it into a retirement account for you.
When you withdraw the money (starting at age 59 1/2), you pay taxes on it then. Usually, however, you will be in a lower tax bracket at retirement age than when you are in your wage-earning years.
This is a gross over-simplification, but that’s the gist of it.
It’s a retirement savings plan - much like an IRA, except you can put more money into it. For a good site, hit the Motley Fool http://www.fool.com
Also, many employers contribute extra dollars in proportion to what you contribute.
My company contributes up to 2% of my salary to my 401(k), not to exceed 1/2 of what I contribute. That is, if I contribute 2%, they’ll put up 1%; if I contribute 4%, they’ll put up 2%. But if I put up 5%, they’ll only put in 2%.
It’s great, because it lowers my taxes, forces me to save (I never see the funds in my pay, so I don’t miss it), and I can borrow against it if the need arises.
One company I applied at had a super 401(k). As a base, they’d put in 3% of your salary. Then they’d match your contribution 3:1, up to you contributing 3% (which they’d match with 9%). So for only 3%, I’d be socking away 15% of my salary for my retirement. Sadly, I didn’t get that job. (They were a non-profit organization that basically would have to pay taxes on their “profit” if they didn’t get rid of it some legal way.)
You don’t have to take the money out when you’re 59 1/2 and you usually cannot take it out until you retire, at whatever age that may be (since there is no longer any mandatory retirement age). Also, I believe that you don’t even have to be employed, but can invest in a 401(k) yourself.
I believe you do have to be employed. If you are not employed, you can invest in a SEP-IRA which will accomplish many of the same things. SEP-IRA caps out at a much higher maximum, though.
The advantage of 401(k) is twofold:
First, as Zev comments, you don’t pay tax on the money now, you pay tax when you take it out at retirement. Deferral of tax has an advantage, especially if you are at a lower tax bracket in retirement (for instance, if your social security payments aren’t taxed but form a large part of your income.) There is a possible downside, if tax rates go up in the future, so that you would be better off paying taxes now rather than later; but most people don’t worry about that.
The second, and the real impact of 401(k) plans, is that the EARNINGS on your money is NOT taxed each year. Those earnings are also not taxed until you take the money out at retirement.
Now, do the calculations yourself. Say you have $1000 in a savings account, and say you can earn 8% each year. Let’s pretend your tax rate is 25%, just to make it multiply easily. So, you earn $80 this year on your savings plan, it’s taxed at 25%, you have $60 left. Essentially, your earnings rate is 6% AFTER TAXES. So, after 20 years, your $1000 will now become (through the magic of compound interest) $3,207.
OK, now say you have that same $1000 in a 401(k), so that you earn 8% a year, which accumulates. After 20 years, you now have $4551; $3551 of that is earnings, taxed at 25%, leaving you $3,840 … compared to the $3,207 in the savings account. Over a longer time period, the advantage is even larger.
Basically, then, the main advantage of the 401(k) is the accumulation of compound interest (earnings) with tax deferral. That provides you with more at retirement than a straight-forward savings account that is currently taxable.
And, may I add, except for a small number of cases, the money you have saved moves with you when you change jobs, either by rolling it into your new employer’s 401k, or by rolling it into an (also tax-deferred) tax-deferred IRA account. (you can also get the money as cash, but this is very, very stupid.)
Also, these are generally investment accounts. Some companies insist that you invest at least partially in company stock, others give tons of options. my plan offers a selection of mutual funds in addition to (optional) company stock. Even if your investments do only so-so, the money your employer puts in makes it a great deal.
Example: my employer puts in 50 cents on the dollar up to 6% of my salary. So, any time I put money into my 401k (every paycheck, dontcha know) I make an automatic 50%, just based on my employer’s contribution. Any gains from the market are just gravy.
Slightest of all nitpicks.
In your example you have a $1000 going inot regular savings and the 401k. But at a 25% tax rate someone would have to earn $1333.33 just to be able to put $1000 into savings. So you should really show how compounding works when $1333.33 is put into the 401k.
Well, yes, Tretiak, but I wanted to make two distinct points.
You made the first point: you get $1333 in cash, it gets taxed at 25%, you have $1000 left to put into a savings account. Or, you get $1333 in cash, you put $1000 into a 401(k), it’s NOT taxed yet, and you are only taxed on the $333, so you have $250 in your pocket, and $1000 in the account.
That’s nice, but ultimately when you take that $1000 out, you WILL pay the tax on it (namely, $250). So while that’s an advantage (you have the use of that money for all those years before you have to pay it), that’s not the point I wanted to make.
I wanted to make the second point, that if you START with the same $1000 to be invested (regardless of where it came from, before tax or after tax income), the major advantage to a 401(k) is that the EARNINGS aren’t taxed. So for that example, I deliberately ignored the source of the initial investment.
So your point is correct, but I deliberately chose not to muddy the waters. This stuff is confusing for non-math persons, and I wanted to keep it simple.
Are there certain other times when you can take out the money?
For example–I can take money out of my ROTH IRA without a fee to use as a house downpayment. Do 401Ks usually have any of those kinds of exceptions? Also–can you not take the money out at all, or are there just really hefty fees before retirement? (Or does this vary from plan to plan?)
I just started a new job and they are in the process of reworking the 401K scheme so there has not been an open period for me to join yet. (In good news they are adding 2 new options so I will have more choices of how to invest) I’m trying to figure out what percent of my salary to contribute when I finally can. My employer will match what I put in up to 5% of my salary so I know I’ll put that much in (I can afford it and I’m expecting a raise before the next open period anyway) but can’t decide if I should put more in or not. I’m 25 and do anticipate getting married/buying a house/having kids sometime in the next few years so I don’t want to lock too much away if there’s no possible way to get it out in case of emergency.
Tax penalties may apply if you retire before you turn 55 and withdraw funds before ae 59 1/2. You can transfer the funds, however, to an IRA or other eligible retirement plan.
You can take what are known as hardship withdrawls from your personal contributions to your 401(K) without penalty (although you still will have to pay tax on it).
Hardship withdrawls are defined as:
- Unreimbursed medical expenses for your immediate family (you, spouse, dependents)
- Payment of tuition and other educational fees for post-secondary education for your immedaite family
- Purchasing your initial primary residence
- To prevent eviction from or foreclosure on your principle residence
ASD - I’m also 25, and done some reading and all and this is what I would tell you: whatever you put in your 401k, LEAVE IT ALONE. You will gain incredible advantages (through the miracle of tax-deferred compound interest) by starting young, even with a relatively small amount of money. Even if you simply stop contributing to it for a period of years it will continue to grow. Set up a separate investment account or saving account or whatever you feel comfortable with specifically for the purpose of saving for first home/child/grad school or whatever. If that means you put less into your 401k, then fine. But pretend the money in your 401k doesn’t even exist, unless say, your house burns down with all your posessions, your favorite dog and your almost-completed dissertation inside.
I read somewhere that if you put some relatively small amount, like $100, away each month from the age of 21-30 (about $11,000, not incl employer contribution, which in my case would be an additional $5,500 and also not incl gains during that period), and then you never contribute any more to the account after that, it will grow into the millions by the time you are in your 60s. (accountants: can this be right?). Whereas, if you make your first contribution at the age of 35, you have to contribute a LOT more to get the same result. A little work now saves a lot of work down the line.
sorry, my numbers were overly enthusiastic. But the returns starting at 35 are HALF of the returns if you started at 25. Starting at 35 w/ $100/mo you end up with 101K, but if you start at 25, you will end up w/200K. This assumes a 6% rate of return. With 50% company contrubtions figured in you’ll get 292K if you contribute $100 starting at 25 and never increase your contribution.
At 8% annual interest rates, your contribution will double over a 9-year period. If you put $1000 into savings at age 30, it will produce around $10,000 at age 60. If you put $1000 into savings at age 40, it will produce only about $4500 at age 60. Those early years are critical for savings!
… and I wish I had done it.
But I warn my kids and go through the math with them.
I was thinking mainly of the emergency type situation (eg–a child is born with severe medical problems and needs thousands of dollars of medical care above my insurance limits or something). I just wanted to know HOW locked up the money would be in a worst case scenario. I’m certainly not planning on accessing the money–I just like to have a contingency plan!
Like I said–at a minimum I’ll be putting in the 5% they’ll match (which will be investing 10% of my salary off the bat). I think I’ll just have to sit down and do some math and figure out how much I think I’ll need for a down payment, how much I’ll need to add to my other savings accounts to afford it, and see if I have anything extra left over to add to the 401K.
Thanks for the info everyone! Here’s another question for you…has anyone seen any recent estimates of what the average person will need to retire on? Or now of any good online calculators to figure out the money you’d have at 60 with different investment amounts? (I could do the math myself, but I’m feeling lazy…)
Now that we’ve gone over why you should contribute up to the limit to your 401K if you can possibly afford it (pre-tax dollars, employer may match, etc), I wonder about something else.
What with working for companies that got acquired, and changing companies a few times (just the way the “Silly Valley” works), I’ve been in several 401K plans. They always give you a very short menu of available investments. Even if the investments are somewhat lackluster, the 401K is still a good deal because of all the reasons mentioned.
What I wonder is, how many various lousy-performing mutual funds continue to exist only because they get included in 401K packages?
This is the quick’n’dirty way
take 60%-80% of your current annual income. think about when you wish to retire. Think about how many years it will be from then till you (probably) kick the bucket. I think the average lifespan for a white male is like, what 76 years? If men in your family live a long time, and you have a generally healthy lifestyle, adjust appropriately. Say to yourself: wow, that’s a lot of money.
This gives you a number pre-soc security (or, if you are cynical like me, you just assume the Soc Sec will be dead by the time you need it) and pre-divesting your assets and pre-any other investments you have.
so like if you’re making $50k now & plan to retire at 60, say $40k x 20 yrs = 800k to maintain your current lifestyle in retirement.