Friday, June 10, 2011
The 411 on the 401k
So what is a 401k? It is a way for employees to defer compensation so that their paycheck is smaller and that amount is put into what is called a 401k. The money inside the 401k is saved and cannot be withdrawn until after the holder turns 59 1/2 years old. Contributions to the play may be either pre-tax or post-tax. Pre-tax contributions will be taxed when the money is withdrawn, and post-tax contributions will not be taxed when withdrawn. The main benefits that I mentioned earlier is due to the power of compounding on the interest, dividends, or capital gains earned. Since tax isn't taken out, your interest will help you earn more interest which will earn you even more interest which will... well you get the idea. The same with dividends and capital gains (if reinvested, otherwise they will just contribute to interest). The act of deferring tax on income alone is also substantial, especially since your income tax rate is more likely to be lower during retirement than while you work.
For example, a worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only recognizes $47,000 in income on that year's tax return. Currently this would represent a near term $750 savings in taxes for a single worker, assuming the worker remained in the 25% marginal tax bracket and there were no other adjustments (e.g., deductions). [example from Wikipedia]
The main downside is that you aren't allowed to touch the money until you reach 59 1/2. There are often penalties for money withdrawn before reaching the eligible age (although there are some hardship circumstances that are accepted) and will also be taxed at your normal income rate. There is also a required minimum distribution starting at 70 1/2 or April 1st the calendar year after retiring. The IRS also places limits on contributions to a 401k. The limit for 2011 is $16,500 and is supposedly indexed for inflation in future years.
Employers are also allowed to have automatic enrollment in 401ks, requiring employees to actively opt-out if they do not want to participate. Make sure you know your company's policy when looking at your retirement plan since you may not want a 401k in place of other plans. Also, beware of administration fees and other fees that may be charged.