Starting Out
Why You'll Love Your 401(k)
Looking for a partner in wealth? Here are five reasons to hook up with your 401(k) at work right now during open enrollment.
By Erin Burt, Contributing Editor, Kiplinger.com
October 4, 2007
Advertisement
On the surface, a 401(k) looks boring. It's all about investing for retirement, has a lot to do with taxes and numbers, and you sign up for it at work ... snore. Not to mention, it's actually named for a section of the tax code. Double snore.
But don't let the Clark Kent disguise fool you. Beneath that nerdy exterior is one desirable catch. After all, your 401(k) (also known as a 403(b) or 457 plan, depending on where you work) can make you a millionaire while saving you money on taxes. What's not to love?
RELATED LINKS | |||
 |
Max Out Your 401(k) | ||
|
|
How Much Will My 401(k) Grow? | ||
|
|
Retirement Plans for the Self-Employed | ||
This is no fling. It's the real thing, and now is a great time to make your move. Fall is open enrollment season at many workplaces nationwide. It's that special time of year when you
Let me count the ways
There's so much to love about your 401(k) that, soon after getting involved, you'll wonder where it's been all your life:
1. It could make you a millionaire. Investing in a 401(k) is a pretty easy way to make a million bucks by the time you retire. Say a 25-year-old socks away $200 a month in a 401(k) earning an average 10% annually. By the time she turns 65, she'll have about $1.3 million saved. (See how quickly your savings could add up.)
2. Your employer may give you free money. Many employers give you money just for having a 401(k). Your workplace, for example, may offer a "match" -- pitching in, say, 50-cents for every $1 you contribute. If that were the deal for our example 25-year-old, she'd have $2 million by retirement. Sweet.
3. It's a low-maintenance relationship. Not to spread rumors, but the 401(k) is easy. To get started, you'll have to fill out some paperwork, tell your employer how much money you want to invest each pay period and pick a mutual fund from a list (see Build Your Perfect Retirement Portfolio for help). But after the initial set-up, you just let it ride. More employers are even signing workers up automatically and determining how much of their pay to contribute -- you don't even have to lift a finger.
4. You don't have to remember to make deposits. Nothing sours a good relationship like forgetting an important date. Not a problem with your 401(k) because deposits are automatically taken out from your paycheck. No matter how busy you are, you'll never miss a contribution, giving your money the best opportunity to grow.
5. You'll have fewer taxes taken from your paycheck each month. Your 401(k) contributions are made before taxes, reducing the amount of income Uncle Sam can get his hands on. Because 401(k)s are tax-deferred investment plans, you don't pay taxes on earnings now, but you will have to pay when you withdraw your money in retirement.
Beyond the rose-colored glasses
Like any new relationship, there are a few small catches:
1. Hands off, buster! Your money is saving itself for retirement. So don't even think about touching it while you're employed until age 59½ . If you leave the company before age 55, withdrawals are taxed and generally hit with a 10% penalty, unless they're rolled over into an IRA or another employer's 401(k). If you are at least 55 when you retire, you can take penalty-free distributions from your 401(k) plan, but you still will owe income taxes.
2. Are you eligible? You may not be able to get friendly with your company's 401(k) program immediately after getting a new job. While some employers will sign you up automatically (unless you opt out), other companies may require you to wait three months to one year before allowing you to open an account. If you're locked out for now, do a little payroll deducting on your own, saving the money in a taxable account until the doors of the 401(k) open. Then double up your contributions for a while, using the money you set aside to make up for the shortfall in your paycheck.
3. Know your limits. In 2007, most employees can contribute up to $15,500 (or up to 100% of salary if less than $15,500) to their 401(k) plan, 403(b) plan, 457 plan or federal Thrift Savings Plan.
In this relationship, the benefits far outweigh the drawbacks.
The competition
There's another wealthy suitor making eyes at you, and its name is IRA. The Roth IRA, to be exact, is one of my favorite investment plans for retirement. It, too, can make you a millionaire, save you money on taxes and offer you a low-maintenance relationship. So which one should you choose? The 401(k) or the Roth IRA?
The decision, for most young adults, will come down to your employer match. If you get free money for participating in your 401(k) at work, that's your first stop because you'd be crazy to pass up that cash.
If you don't get a match at work, start investing with a Roth IRA first. Why? You fund a Roth with after-tax dollars, but all your money is tax-free in retirement (that's the opposite of the 401(k)). Because you're probably in a lower tax bracket now at the beginning of your career than you will be when you retire, you'll pay fewer taxes now with your Roth than you will later with your 401(k). Plus, you're more likely now to fall within the income limits for contributing to a Roth. Learn more in Why You Need a Roth IRA.
But that doesn't mean you can't have your cake and eat it, too. If you don't get a 401(k) match at work, max out your Roth IRA first ($4,000 this year). Then, make contributions to your 401(k). It's perfectly legal to two-time these tax-sheltered investment accounts and enjoy the financial benefits of both. Sometimes it really pays to play the field.