As if the world of savings and investment wasn’t complicated enough, when it comes to retirement planning, the conversation always seems to start with enigmatic numbers — 401(k). The numbers themselves are fairly meaningless; they’re simply the formal designation for the section of the Federal tax code that sets the rules governing tax-sheltered savings plans.
Simply put, a “401(k) plan” is an investment vehicle set up by your employer that allows you to delay paying taxes on monies you invest in the plan and permits the employer to make tax-deferred contributions (sometimes in the form of “matching”) on your behalf. The funds go into investments held by the 401(k), and you won’t pay taxes on the money contributed — by you or your employer — until you withdraw money from the plan. As you might imagine, 401(k) plans are subject to a number of additional rules and regulations, but this is the basic idea.
TAX AVOIDED VS TAX DELAYED
It’s important to understand that you’re still going to pay tax on the money in your 401(k); you’re just not going to pay it until you withdraw the money, presumably after retirement. And here’s the genius of the 401(k). By not taxing the money right away, you have more money at the outset that can be invested, that extra money being the tax that you would otherwise have paid on the income.
When your employer adds matching funds, the amount you’re investing is even higher. The total amount you’ve invested — including the tax you didn’t pay — can work and grow until you’re ready to begin withdrawing from the account after age 59 1/2. You can withdraw money from a 401(k) prior to age 59 1/2, but you’ll pay income tax on the amount withdrawn plus a penalty for early withdrawal, except in special circumstances which will be discussed in Part 2.
HOW DOES THAT WORK AGAIN?
Let’s look at an example: Laura is 40 years old and works for the Lemur Emporium. The Emporium has established a 401(k) plan for its employees and Laura wants to be part of it. She feels she can afford to contribute $250 a month, which amounts to 6 percent of her salary.
The Emporium has agreed to match Laura’s contribution, one dollar for each dollar she contributes, up to 6 percent of her salary. If Laura contributes 6 percent of her salary to take advantage of the full contribution the Emporium is willing to make, 12 percent of her salary amount will go into the plan — the first 6 percent is deducted from her paychecks, and the Emporium adds 6 percent of her salary as its match.
If Laura’s salary is $50,000 a year, then the amount going into her 401(k) is:
$50,000 x 6% = $3,000 (from Laura)
$50,000 x 6% = $3,000 (from the Emporium)
= $6,000 total contribution
Laura will not pay income tax on any of that money until she withdraws it. So let’s see the difference that makes to her long-term retirement planning. Without the 401(k), Laura would have to pay income tax on her $3,000 contribution. Laura’s income puts her in the 25 percent tax bracket, but as a single filer with the average amount of deductions, she might actually pay about 12 percent of her salary in Federal income tax. In that case, after tax, Laura would only have $2,640 to invest.
Without ever investing another penny, and assuming an 8 percent rate of growth on the investment that is compounded annually, in 20 years that money will be worth more than $12,000. However, if the same investment is made through the 401(k), the whole $3,000 gets invested. Assuming the same 8 percent rate of growth, at the end of 20 years, the investment will be worth close to $14,000. That’s nice. But the 401(k) can do a whole lot more than that when the company match kicks in, which we’ll discuss more in Part 2.