How do 401(K)s work?
401(K) plans are tax-deferred retirement savings plans for employees known as “defined contribution” plans. When you join a 401(K) plan, you tell your employer how much money you want to contribute to your account. This amount is deducted from your salary before taxes are applied, so you pay less income tax. More importantly, the money is deducted even before you have received it, making it the easiest savings plan to contribute to. Your employer may match a portion of your contribution. The money is invested by the plan administrator (on your behalf) in mutual funds, bonds, money market accounts, etc. You decide the mix of investments. There are usually a list of investment vehicles you can choose from as well as some guidelines for the level of risk you are willing to take.
Since the plan is an incentive for retirement savings, there is one condition: if you withdraw the money before you are 59 ½ years old, you will have to pay tax as well as a 10% penalty fine to the IRS.
Why should you invest in a 401(K) plan?
There are several reasons why investing in a 401(K) plan is advantageous to you:
- The money you contribute is free from Federal and State taxes.
- Your employer receives tax benefits for contributing to your 401(K) – this is extra money for you.
- There is a range of investment options and an expert does the actual investing according to your directions.
- Any gains and earnings through this investment are also tax deferred.
- You can take loans and hardship withdrawals under certain circumstances if allowed by the plan.
- The money is deducted even before you receive your salary, making it easy to for regular saving and investing.
Did you know that increasing your retirement contribution by 1% will give your retirement a real boost?
Increasing the amount you contribute to your retirement account by just one percent can really boost your savings potential. Assume you are making $35,000 per year and contributing 5% of your salary to your 401k. That equals around $146 per month. In 20 years assuming a hypothetical rate of return of 8%, that savings could potentially grow to almost $86K. By increasing by just 1% (which is only around $30 more per month), than can potentially mean an additional $17,176 in twenty years to your retirement!
When should you borrow from your retirement?
If you take money out of your 401k to pay off your debts, you will most likely regret it later. Taking out a loan or an early withdrawal will reduce your eventual retirement account. By taking money out of your 401k account, you reduce the benefits of tax-free compounding that is key to building up a substantial balance. Let’s take Bob who is 35 years old earning $40,000 a year and has a 401k balance of $20,000. Bob contributes 6% of his salary ($2,400/year) and his employer match is 3% ($1,200). At a rate of return of 8% at age 65, his retirement nest egg is $583,723. We will assume Bob took a $10,000 loan out when he was 35 and took 5 years to pay it back at an interest rate of 5%. When Bob reaches age 65, his account is now worth $458,673. So it cost Bob $125,050 to borrow $10,000. That is the effect of tax-free compounding!
Loan defaults can be harmful to your financial health!
If you quit working or change employers, the loan must be paid back right away. It is not uncommon for plans to require full repayment of a loan within 60 days of termination of employment. “In default” means your employer will report to the government that you were unable to pay the loan, and the government will then treat the defaulted amount of your loan as a distribution. This most likely will lead to regular taxes on the defaulted amount plus for those under 59 1/2, the ten percent additional federal income tax penalty will apply. Depending on your tax bracket and the tax rate of your state, you could be forced to pay the government as much as half of the defaulted amount. The interest on the loan is not tax deductible and you will be responsible for the loan fees. Finally you have no flexibility in changing the payment terms of your loan.
Simply stated, it is not wise to take a loan out of your 401k plan. When you put your money in your retirement account, keep it there!
