All retirement plans are not the same. In fact, there is such a wide variety of retirement plans that learning more about your choices is a good idea. Here’s a brief look at the basics of 401k plans…
How do 401k plans work?
Many people have a 401(k) retirement savings plan, which works like this: The plan is funded with pretax dollars taken out of your paycheck (through payroll deductions). If you’re lucky, your company will match your level of contribution or even make contributions on your behalf—after all, the employer contributions are tax-deductible.
How much can you contribute to your 401k?
In 2009, the IRS will let you contribute up to $16,500 a year in a traditional 401(k). However, many employers will let you contribute only up to 10 percent (or less) of your annual salary. The IRS also allows catch-up contributions (additional contributions from those age fifty and above), with a current annual limit of $5,000.
Do you have a million dollars? At the moment you may not have it, but if you invest and save diligently and let your assets compound, who knows? You may be a millionaire someday. In fact, you may need to be a millionaire someday. If you stay retired for twenty or thirty years—which could happen—it may take well over $1 million to fund that retirement.
For years, employers have wondered: Why don’t people contribute more to their 401(k)s? At the typical large company, the majority of employees contribute too little, and some find it a hassle to even fill out the paperwork. Most people don’t speak “financial” and don’t look at financial magazines or websites. It’s “boring.” So they mentally file “401(k)” under “boring.” But the advantages of a 401(k) should not bore you; they should motivate you.
How much can you make in a 401k?
The money in your 401(k) compounds year after year without tax penalties. The earlier you start, the more compounding you get. Let’s say you put $2,400 annually in a 401(k) starting at age thirty, and, for the sake of example, let’s assume you get an 8 percent annual return. How much money would you have at age sixty-five? A retirement nest egg of $437,148 could result from putting in $200 per month. But if you started putting in that $200 a month five years later, you might have only $285,588. As stated above, you can put up to $15,500 into a 401(k) in 2008, and if you are age fifty or older, you are allowed up to an additional $5,000 in “catch-up” contributions. Who would turn down free money? Big companies will often match an employee’s 401(k) contributions. A typical corporate match is 50¢ for each dollar up to 6 percent of your salary.
Are 401k contributions taxed?
Many employees don’t recognize this benefit. Your 401(k) contributions are pulled out of your wages before taxes are withheld (pretax dollars). So you get reduced taxable income (less for Uncle Sam) and tax-free growth; you pay taxes on 401(k) assets when you withdraw them from the plan. With the new and increasingly popular Roth 401(k), the contributions are after-tax (no reduction in taxable income), but you can enjoy both tax-free compounding and tax-free withdrawals.
Why not take advantage? If you don’t contribute greatly to your 401(k), 403(b), or 457 plan, you may be ignoring a great retirement savings opportunity. Talk to your financial advisor about the 401(k) and other great resources to help you save for retirement.
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