What is it exactly? A 401(k) is an employer-sponsored defined contribution retirement plan. Sounds complicated but it is precisely what it says. Your employer will allow you to contribute a portion of your salary into investments that you choose for your retirement. In many cases your employer will even match or partially match your contribution.
Here are two reasons why a 401(k) plan is actually a good thing:
1. Tax Break. By investing in your future you actually save money on your taxes. Let me illustrate this with an example. For simplicity’s sake, let’s say you make $100 per month. If your tax rate is 20%, you would be paying $20 in taxes each month, and your income after taxes would be $80. Now, let’s say you decide to contribute $10 to your 401(k) plan (of your $100 income). This deduction is made on a pre-tax basis, meaning that you don’t pay taxes on the income you contribute to the plan* (this is the government’s incentive to get you to save). After the contribution, your taxable income would be $90 and your taxes would be $18 at the same tax rate — you just saved $2 in taxes (this may not seem like much but this savings adds up over time, even with your $100 income). Your income after taxes would then be $72. While it may seem like you have $8 less in your pocket right now, you actually have an additional $10 in your retirement account. Which brings me to my second point…
2. A little bit goes a long way - it’s never too early to start investing. While most of us who are new to the working world won’t realistically retire until 2050 or beyond (scary thought, I know), it’s not too early to start planning for your retirement. Money that you put away early in your career will earn interest until you retire. Investments are compounded over time; the interest you earn at the end of the first month is added to your balance (the principal) when calculating the interest for the second month. This means that you’re earning interest not only on your principal but also the previous month’s interest.
Let’s again look at the $10 that we put away for retirement in the first month of working and assume that it is the only retirement contribution you ever make in your whole entire life (let’s hope this is not the case). We’ll assume that you did a relatively decent job investing that money and it’ll grow at a rate of return of 7% per year until 2050. At that time your $10 contribution will become $187.50. Now, just think about what would happen if you invested $500 in your first year of working and then never invested in your retirement again (still, not the best idea). The day you retire you’ll have approximately $9,400. Early investment in your retirement means the money you put away first will be in your retirement account the longest, be compounded the most times, and therefore earn the greatest return overall. The amount you invest doesn’t have to be large (like we saw with our hypothetical $10). Just imagine how much you’ll save if you invest throughout your entire career!
With the dwindling status of social security, saving for your own retirement has become increasingly important. Just because it’s important, doesn’t mean that it has to be difficult. Stay tuned for 401(k) 101b (my second installment in this series) where I’ll address more issues and characteristics of employer-sponsored defined contribution plans.
In the mean time and since I’m here to help you — leave any questions below in the comments and I’ll be sure to blog about what you want to know!
*Don’t get too cozy, this money will be taxed when you take it out at retirement.
