The 401(k) plan is one of the most widely used retirement vehicles. It is established by employers for their employees to help them realize their retirement goals. The biggest advantage is that you can save a ton of money on taxes.
To demonstrate the tax benefit in a 401k account let’s take an example of a man at 2 stages in his life:
Mr. X has joined a company at age 30 and gets an annual income of $100,000 out of which $10,000 is allotted before tax to his 401k account with his company. He will pay taxes on the remaining $90,000, but not the $10,000 he put into his 401(k). With such a large income, he will be put into a high tax bracket, so his tax saves would be quite large.
Mr. X has reached 65 years of age; after retiring he wishes to redeem his money collected over the years in the 401k account along with any growth he received on his investments. He will have to pay taxes on any money he pulls out of his 401(k). But since he is now (presumably) pulling out less money than he would have made when younger, he will have to pay a comparatively lower amount of taxes. More importantly, his money will have been growing tax free for years before the government could take its cut.
How much more money is in Mr. X’s pocket from him putting money into his 401(k) instead of in a regular, taxable investment account? Assuming 8% compounded annual growth rate and that he saved $10,000 every year, the 401(k) account would have $1.87 million versus $1.25 million for the taxable account. That is about $600k difference!
Here are a few 401(k) tips to ensure that you make the best out of your 401k plan:
Many companies and employers will match the amount you put into your 401k account. (Basically it’s free money) but typically the “match” amount is a percentage of your 401k contribution.
For example, let’s say that you deposit $1000 into your 401k account this year and your company gives you a 50% “match”. This means that in the end the total amount going into your 401k account is $1500.
There are limitations to the amount of free money the company puts into your 401k account. In most cases the limitation is up to 6% of your gross annual salary.
Getting every possible matching dollar should be a priority of every individual who has a 401k account with his or her employer because it is free money.
Rollover your 401k account to an IRA (individual retirement agreement) with Vanguard if you leave your company before retirement
A 401k rollover is the step taken when you leave your job at your company before retirement age and instead of withdrawing your collected money from your 401k account (and taking a tax hit and 10% penalty), you wish to keep it growing until your retirement age. You can then transfer the money from your 401k account into a fund managing company’s IRA account and still avail the tax benefits when you retire.
For example, Mr. A worked for a good company for 10 years and has a decent amount of money collected in his 401k account. If Mr. A quits his job at age 40, it will become a huge headache to transfer funds from his company’s 401k account to another one. If he chooses to withdraw this money before his retirement age then he is liable to face a penalty from the IRS. In such situations the best thing to do is to rollover your 401k account to an IRA with a good company like Vanguard.
Vanguard has the lowest fees in the business. These frees will be deducted directly from earnings in your IRA account. At the same time Vanguard only charges you the amount of money they themselves would need to run the fund. They get no profit on the cost you pay them. This list should give you a little assurance and peace of mind if you are stuck in the “rollover” dilemma https://personal.vanguard.com/us/insights/article/money-magazine-best-funds-01112012
Do not have your own company’s stock in your 401k account.
Many times people think that since they love their company and since they work within it, they can trust in its stability for something as important as a 401k account. You may wish to have a share in your company’s success. However it is extremely unadvisable to invest in your own company stock.
Since you depend on your employer for a livelihood more dependence should not be given to the company stock. When companies crash and burn, it often happens quickly.
Your company may even impose restrictions on how you use the company stock within your 401k account.
Thus it is better and smarter investing in broad index funds such as the S&P 500. These funds give you the benefit of diversification and hence lower your risk
Check fees before investing
Like any other financial vehicle, the 401k has certain fees you pay every now and then. These fees could be eating through your returns if you fail to monitor and control them.
Flat fee amount: here the fee amount is constant regardless of the amount of money you invest
Percentage floating fee: the fee here will be a percentage of the amount you invest.
Investment management fee – this is the fee taken to manage your various investments within your 401k account. They usually go unnoticed as they are directly deducted from the returns on your investment
Individual service fee – fees paid on services against the 401k account. For example if you take a loan from your 401k account a service fee will apply to you.
With the volatility in the markets these days along with heavy recession and unemployment; you certainly don’t want to be losing your returns when you are in high risk of losing your job. You require an active management attitude to tackle the active market. Constant diversification along with the prompt and proper monitoring of market prices is a necessity in today’s volatile economy.
The above paragraph is what many people believe is necessary to be a successful investor. Fortunately for you and me, they are wrong. You do not need to constantly monitor your investments. In fact, studies have shown that constant monitoring actually has a negative impact on your investments.
What you need is a good, solid investment plan that you stick to through the highs and lows. I go over the best ways to invest money here.
The 401k is a great financial vehicle to secure a wealthy and care free retirement if properly managed and taken care of.