What’s Great About a 401k?

There are some nice advantages to using a 401k for your investments. First, some employers match your contributions. For example, a company may match half of what you put in. They usually add an upper limit on how much they match, such as six percent. So if you put in six percent of your pay, they would add another three percent, for a total monthly savings of nine percent of your pay.

Let’s say you make $40,000 per year. Six percent is $2,400 per year. The company would throw in another $1,200. That is, the company will give you a raise just for contributing. Another way to look at the company match is that you’ve just made a 50 percent gain on your investments. Even the great stock market investors would be delighted to have a guaranteed instant 50 percent return.

Another common match is dollar for dollar on the first three percent of your pay that you contribute. That gives you a 100 percent return on your money. It’s a fantastic deal. Just remember, though, that under this formula if you contribute more than three percent, the company does not match the extra amount. While not all companies match employee contributions, there are more good reasons to enjoy your 401k.

Another great thing about your 401k is the tax deferral and compound interest that vastly increase your 401k’s growth rate. For instance, with a regular 401k, your contribution goes in before taxes are collected. In the example of the $40,000 worker who contributes $2,400 a year to his 401k, the government pretends that this person is only earning $37,600. They don’t completely ignore the 401k contribution, but they allow it to grow tax deferred, not taxing it in the year that you earn the money and contribute to the 401k.

After you retire and withdraw some of the money in your 401k, the IRS will say that it’s time for you to pay some tax. Even after paying the tax, you will be ahead of the game because your earnings compounded every year without a tax bite. Later on, I’ll show you some numbers about how much better off you are when you let your money compound without taxes. For right now, trust me on it.

You may have a choice about whether to set up a regular 401k or a Roth 401k. They have very similar advantages, but one key difference. With a Roth, you have to pay taxes on the money that goes into the 401k, but you pay no taxes at all when the money comes out during your retirement.

Compound growth is the key to the whole thing. You may be more familiar with the term “compound interest.” Compound growth is the same idea, but recognizes that some of your gains are from dividends and increasing prices of stocks, not interest.

A third great thing is that your savings is automatic in a 401k. Most humans have a tough time putting money away for their retirement. I’ve heard that beings from the planet Zorg always set aside money for the future before spending money on today’s needs and wants. Unless you are from that planet, you probably have a hard time saving. The 401k is great for you. The money goes directly from your company into your account, without ever tempting you to spend it.

Do you want to be a millionaire, while earning only an average salary? Not a problem if you contribute to your 401k and your employer offers a match of, let’s say, three percent on top of your contribution of six percent. Let’s say that you are smart enough to read this when you’re only 22 years old, and you plan to retire at age 62. You don’t want to take extreme risk, but you can accept moderate fluctuations in your investments. If your income is right at the middle of the income distribution ($46,000 as of the time I’m writing this), you’ll make it with your 401k! (Oops, I can’t actually guarantee that. You’ll learn more about investment returns later on, but I can say that the most likely case is that at age 62 your 401k will have $1,080,095 in it.)

The 401k is one of the truly great investment vehicles open to employees today.

About the Author

“The ABCs of Your 401k” is a free, on-line course that elaborates on this and other aspects of your 401k, at http://www.abcinvesting.com. The course was created by the author of this article, Dr. Bill Conerly, chief economist of abcInvesting.com, which provides accurate, basic, and clear investing information. ©2009 abcInvesting.com LLC

Comments are closed.