When I got my first job in New York, the Company sent me a retirement brochure in the mail highlighting 401K features and options. Like many people that start off working, I had no clue what a 401K was nor how it worked. Luckily, that brochure sparked enough interest for me to learn and open my 401K with the Company. A 401K is a retirement savings plan offered by U.S. employers where employees can elect to set aside a percentage of their paycheck to be sent directly into an investment account. Most 401K plans provide a variety of investment vehicles including money market funds, Bond mutual funds, and stock mutual funds. In 2022, employees of a business with an offered 401K will be allowed to contribute up to $20,500 per year. The first thing that may come to your mind is, “Why would I want to reduce my paycheck”? If your Company offered you a 401K, I’ve listed out 3 reasons why you should consider contributing to your 401K.
1. Tax Advantages
When you elect to set aside a percentage of your paycheck to a 401K plan, your contributions are tax-deferred meaning that any money that is in or grows in the account is tax-free until you withdraw the funds at retirement. Since contributions to your 401K is pretax, your taxable income immediately is less meaning that you immediately pay less taxes. For example, if you were taxed at 20% of your taxable income, $100 earned would mean you would have $80 post taxes ($20 tax bill). If you contributed $10 to your 401K pre-tax, then your taxable income would decrease to $90 meaning that you would have $72 post taxes ($18 tax bill). If you withdraw funds from a 401K before you reach 59.5, you’ll be penalized with a 10% early withdrawal fee with any applicable taxes. However, the tax-deferred earnings can be a significant benefit if you are in a lower tax bracket when you decide to withdraw your money funds compared to when you were making contributions.
2. Matching Contribution
Many employers offer to match your 401(K) contributions meaning that for every dollar up to a certain percent of your salary, your employer will contribute a dollar to your account. The average 401K percentage match is around 5% of salary up to $3,000. Under this scenario, a person making $60,000 who contributes 5% of their pre-tax income would have contributed $3,000 to their account and would get an additional $3,000 from their employer totaling $6,000 at the end of the year excluding any growth that happened throughout the year. In other words, not contributing the 5% every year would mean that you are essentially passing up free money. Every employers 401K matching program differs with several variations including a partial or Dollar for Dollar programs. Given several Americans don’t have enough money saved for retirement, your employee contributions compounded over several years can be a powerful strategy as part of your retirement savings goals.
3. Loans
Several 401K plans give you the option to borrow from your account for certain reasons including buying a primary residence, paying for education or medical expenses, or for qualified cases of economic hardship. Most 401K plans allow you to borrow up to $50,000 or 50% of the value of your account which you must repay with interest. The interest you pay on your loan is paid towards your own account meaning that the borrowing expense is minimal. In addition, the interest on 401K loans are usually less than the cost of paying interest on a bank or consumer loan and do not involve any credit history checks. Regulations require most 401K loans to be repaid within 5-years, but can be repaid sooner with no prepayment penalty. Overall, taking a 401K loan is the simplest and lowest cost way to get cash you need without having your credit history checked.
Final Thoughts
A 401K offers a triple threat offense towards your retirement goals. The tax advantages to both contributions and earnings can be substantial when compounded year over year until you retire. If you started contributing roughly $3,000 a year to your 401K with a 6% growth rate from age 25 to age 65, you would have contributed $105,000, but the value of your account would be roughly $334,000. Using the same scenario, assuming a 5% match or $3,000 match from your employer every year on top of your $3,000 contribution would yield a portfolio worth $668,608 by age 65. The most common argument against contributing toward a 401K is that your money is essentially locked from you until age 59.5, but 401K loans allow you to essentially borrow from your account with low cost to you. Overall, it’s hard to pass up the benefits of a 401K and if you can afford to contribute and don’t have any investments that yield more than 6-8% on a consistent basis, I’d at the very least contribute the maximum amount matched by my employer.
