Great Savings Tip #76

Published February 4, 2011

Today’s tip: Invest In A 401K.

This post is part of our continuing Great Savings Tips series, designed to help find ways to spend less and save more. Join us for new tips every week until we bring our tip count “All The Way To 100!”

Huge Benefit

Tip #76) Invest in a 401K. This tip applies to those who are employed by companies offering a 401K plan. A 401K is a huge employee benefit that can make working for a company who offers such a plan an important key to long-term financial success. Basically, a 401K is a retirement plan. You put in “pre-tax” earnings and distribute the money among investments the plan administrator offers. Though investment choices may be limited, there are typically a number of well-diversified stock and bond holdings to choose from. FYI: By law, administration of the plan will be done by a company other than the one you’re working for. These are often well-known firms like Vanguard Investments, Wells Fargo, etc.

Reduce Your Taxable Earnings

Investing in a regular 401K reduces your current taxable earnings. If you make $50,000 a year and can invest 10% into your fund, that means you’ll pay income taxes on $45,000 instead of $50,000 ($50,000 x .10 = $5000 so $50,000-$5000 = $45,000). That means your income tax bill for the year is less, plus all the earnings on your investments are compounded tax free until the funds are withdrawn. This makes a 401K both a tax deferral plan as well as a savings plan. If you’re not concerned about reducing current taxes, there is another option to consider, a ROTH 401K, which basically taxes you as you go along, instead of at retirement. For further information and other links see ROTH401K.com.

Over time a 401K match is a little like having your own cash cow.

Free Money

The reason 401K’s are so powerful is that companies typically match a portion of an employee’s investment. This is FREE EXTRA MONEY as far as an employee is concerned. It’s like getting a huge bonus just for working at the company and deciding to participate in the 401K plan. In fact, not taking advantage of an employer match program is a little like throwing your money away. And over the course of your career, this free money can compound and amount to thousands of extra dollars you’ll be able to spend in retirement.

How does the match work? Say I tell my company to take 10% out of my $2000 paycheck every month and put it in my 401K. If the company offers a match, they will also deposit a set amount of cash into my account as laid out in the company plan—50¢ on the dollar for up to 6% of annual salary would be a typical company match. In our example that works out to ($2000 x .06 x $.50 = ) $60 per month or $720 per year. That means my $200 monthly 401K investment (i.e. $2000 x 10%) becomes a $260 monthly 401K investment instead. Plus, once the company puts the funds into my account it’s mine to invest as I see fit. Companies can decide what amount of employee contributions they intend to match, or whether they intend to match employee contributions at all. It can vary every year—they will look at their profit and determine what portion they want to fund. Companies like this flexibility.

Retirement Tool

401K’s are a terrific way to sock away money for retirement. As long as you can afford the hit to your monthly budget, it always pays to put at least as much in each year as the company matches. And unlike pensions, when you invest in a 401K the money in your account is your money. That means you won’t have to worry that either a company bankruptcy, or poor management will take it away, though you still need to consider market risks (i.e. the risk that stocks or bonds may suffer periodic declines).

Another plus: If you switch jobs down the road, you can take your 401K with you to your new firm or transfer it to an IRA—this is called a rollover. Note: if you intend to rollover your funds, be sure it’s a direct rollover, which means direct from one institution to another. Otherwise, you could end up paying a penalty. Also note that the rules for 401K’s changed a couple years ago. The biggest change was the limit employees are allowed to contribute to their fund each year. For 2010, those under 50 could contribute $16,500 and those over 50 could make so called “catch up” contributions up to $22,500. If you’re over 50, this may be a strategy worth pursuing depending on your current and future financial needs.

Get To Know Your Plan

401K’s have certain restrictions and penalties for withdrawing your funds early. Remember: This is a retirement plan which means using the money for purposes other than your planned retirement may cost you. Unless you qualify under a certain specific exemption, when you withdrawal funds early (i.e. before age 59 ½), you’ll pay a whopping 10% penalty on top of any additional income taxes. Employees can take loans on their 401K that can serve in an emergency, but they need to pay them back with after-tax income and pay interest. Before withdrawing funds from any retirement plan, take the time to understand the consequences.

For more information on 401K’s see Wikipedia: 401K, the Internal Revenue Service, or check with your 401K administrator or Human Resources representative.

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By Bob Anderson