When you start out your career, you are usually given the option to save for your future retirement through your employer-sponsored retirement plan - the 401(k). There are certainly other similar type retirement plans, but the 401(k) is the most popular.
So you are ready to commit to saving for your retirement and have setup an automatic contribution from each paycheck to contribute a percentage of your income. You’ve also researched your various investment options and have chosen a low-fee index fund. Great job!
However, you start to wonder, why exactly am I choosing this retirement plan to save for my retirement? Why not just let the money build up in my savings account, or maybe I should open a taxable investment account?
Let’s talk about the benefits of the 401(k), to give you a good understanding as to why you want to put every dollar you can into this retirement account. And finally, to keep today’s discussion straight-forward, we will only be discussing a Traditional 401(k), as we will get into the Roth 401(k) and Roth IRA at a later date.
In my opinion, this is one of the biggest benefits of the 401(k), while also the least known benefit. The 401(k) receives a special amount of creditor protection, with only the IRS and an ex-spouse in a divorce proceeding potentially having access to the savings. During any type of bankruptcy proceedings, 401(k) assets are completely protected.
Traditional 401(k) contributions are not subject to current income taxation. This means if you earn $100,000 in a year and contribute $18,000 to your 401(k), you only pay tax on $82,000 of income.
Along with receiving a tax deduction with contributions to the 401(k), participants also receive the benefit of tax deferral. This means that you will not pay taxes on any type of dividend, interest, or capital gain as long as the money stays in the 401(k). Not having to pay taxes on any type of growth year after year helps your account grow faster than it would if watered down by taxes.
The easiest money in the world to earn is matching contributions, I am convinced of that. Most employers that have a 401(k) plan also offer a matching contribution to help you save for retirement.
For example, an employer may say they will match 100% of your contributions up to 3%. All you have to do is contribute at least this same amount yourself and you immediately double your money. Take advantage of this generous offer from your employer.
One of the easiest ways to save for retirement is to set it on autopilot. The easiest way to set your savings on autopilot is to save your money before it ever hits your checking account! A great benefit to the 401(k) is that your contributions are automatically deducted from your paycheck, leaving little work to be done on your end to begin saving.
For those with a lower income, you may be eligible for the Saver’s Credit, where the government literally pays you to save for your retirement.
Here’s how it works: If you are single and earn $18,500 or less, you will receive up to 50% of your retirement contribution back in the form of a tax credit (or $2,000 whichever is less). So if you earn $18,000 and contribute $4,000 to your 401(k), the IRS will give you $2,000 cash when you file your taxes next year. The tax credit scales down to 10% of the contribution if you earn up to $31,000.
For married filing jointly households, the 50% (or $4,000 whichever is less) tax credit applies to income up to $37,000 and scales down to 10% of the contribution for incomes up to $62,000.
In today’s world, where employees switch employers more often than ever before, it is important that 401(k)’s are transferrable. This means that if/when an employee changes jobs, they can transfer their 401(k) to their new employer. If the new employer does not offer a 401(k) or other similar retirement plan, the 401(k) can be rolled over into an Individual Retirement Account (IRA).