What is A 401k Plan?

One of the great safety net in modern times is the Social Security system. It’s a fantastic retirement income system that has enabled many retirees to live out their golden years in a dignified manner. But Social Security was never meant to be the sole source of income for retirees. But many people don’t understand that Social Security was never meant to be a seniors sole source of income. It was meant to supplement their existing earnings from pension payments and other investments. Recognizing that people were not saving their money as diligent as they perhaps should, the government began to create incentives to help them save. The 401k plan came about as a way to encourage people to save money for their retirement years by giving them certain financial incentives.

A 401k plan can be described simply. It’s a retirement plan designed for workers in a company. The plan is set up so that both employer and employee can contribute to it, but it’s managed by the company. The necessary, but enormous, advantage of a 401k plan is that it allows you to invest your money before it is taxed. All monies that you earmark for the 401k are placed into the plan pre-taxed. In addition, the money is able to continually earn untaxed interest on your donations until you withdraw the money - typically at retirement. And even then, only the money that you withdraw from the fund is taxed. Presumably, since you’ll be at a lower income level when you retire, the amount of money that you will be taxed will be lower as well.

The most amazing part of a 401k plan is it’s tax free compounding effect. This can literally result in an ultimate retirement income of thousands or even hundreds of thousands of dollars more than the same investment placed in a taxed investment vehicle. For example, assume that you are in the 25% tax bracket and have $1000 invested in an investment vehicle that is paying you 8%. At the end of the year, you have earned $80. But after taxes, you have netted only $60 - effectively giving you a real 6% return on your investment instead of 8%. If your investment vehicle had been a 401k, however, you would have paid no taxes at the end of the year. Thus you would have netted the full $80.

Now eventually, of course, you’ll have to pay taxes - but in the meantime, you have the full use of all profits derived from your investment and are able to let them compound unencumbered. If you invest more than $1000 a year in your 401k plan, which many people do and if your investments average more than 8% a year, you could realistically come out thousands of dollars ahead when your retire.

Some employers entice workers to join their company by touting their generous 401k packages. In better economic times, it was not unusual for a company to match the employee’s contribution with an equal amount of their own. So if you contributed $100 to your 401k plan, they would kick in another $100, in effect giving you a 100% gain on your money even before your investments kicked in.

In the current recessionary economy, however, those generous packages have become harder to come by. In addition, fewer companies than ever are offering pensions to their employees, making it even more important that you take control of your own retirement plans. So even if your company has a 401k plan, but no matching program in place, you should still definitely take advantage of it. When you retire, you’ll be glad you did.