As we start the new year, I wonder how many people have taken advantage of the various types of retirement plans that were available to them during the previous year. Whether employer-sponsored plans or the various iterations of Individual Retirement Accounts, it is clear to me that most people do not optimize those plans. This is likely a function of not really understanding how they work. So hopefully, this will help you learn how you can get the most from your retirement plan.
I would like to discuss the retirement plan that is most commonly offered by employers. That plan is known as a 401(k) account. The name 401(k) refers to an IRS code section that describes the account. A 401(k) plan is a retirement savings account that allows employees to “defer” receipt of a portion of their salary and redirect it to their 401(k) account. The employee can choose how their contributions are invested from the choices in the plan. That’s a nice and convenient way for you to save for retirement, right?
Well allow me to unwrap the real gifts of these plans. First, if you have a typical 401(k), your contributions will not be assessed federal or state tax-withholdings. For many employees, that translates into saving 8-15% per-dollar of contributions that you make into your 401(k) as opposed to receiving that money in your paycheck. And while the account grows through the years, there will be no income tax on the increase or profits in the account. So if Kris Kringle contributes $5000 to his 401(k), he could save $750 by eliminating tax-withholding and if he makes $2000 in earnings he will not pay any current income taxes on them either. That means your account earnings compound in three ways; on your contributions, on the prior earnings and on tax dollars you haven’t paid. If your employer likes playing Santa, then some of your own contributions may be matched, as well. With or without the match, if you do not direct as much of your salary into the 401(k) as possible, you are electing to pay more in taxes and, of course, choosing to save less for your retirement years.
Although 401(k) plans can have a wide array of features, the primary benefits mentioned above are invaluable year-over-year and will make a tremendous difference during your retirement.