As we start the new year, I wonder how many people used the various types of retirement plans available to them during the previous year. This includes employer-sponsored plans and the many kinds of Individual Retirement Accounts. Still, it is clear to me that most people do not optimize those plans. This is likely because they do not really understand how the plans work. So I hope this article helps you get the most from your retirement plan benefits.
How a 401(k) Plan Works
First, I would like to discuss the retirement plan that employers offer most often. That plan is the 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 lets employees “defer” receipt of a portion of their salary. Instead, they redirect it to their 401(k) account. The employee can choose how to invest their contributions from the choices in the plan. That’s a nice and convenient way for you to save for retirement, right?
Unwrapping the Retirement Plan Benefits of a 401(k)
Well, allow me to unwrap the real gifts of these plans. First, if you have a typical 401(k), no federal or state taxes come out of your contributions. For many employees, that translates into saving 8-15% per dollar you contribute, as opposed to receiving that money in your paycheck. Also, while the account grows through the years, you pay 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, it may match some of your own contributions as well. So, with or without the match, direct as much of your salary into the 401(k) as you can. Otherwise, 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, these core retirement plan benefits are invaluable year after year. They will make a tremendous difference during your retirement. To see how a 401(k) fits into a complete plan, visit our retirement planning page.