401k Introduction
The original 401(k) plan was created and set into motion by Congress in the year 1978 as a way for people to save up for their own retirement before they had to pay taxes on that income. This was done in an era were the traditional pension plans already seemed to be shrinking if not completely disappearing all together and therefore there was a serious perceived need for some method of investing and saving that would encourage employees in a variety of different industries to take control of their own financial future and their own retirement rather than completely and fully relying on the government. As it turns out, not only was the 401(k) plan one of the worst things that has ever happened to workers in America but it has also simultaneously turned out to be one of the best things as well.
So what is a 401(k) plan?
In essence, what a 401(k) plan is, is an investment account that has deferred tax treatment attached to it. What this means is that every single dollar that you save in your 401(k) plan today is going to reduce your tax liability for this year by the exact same amount. For example, if you earn $50,000 dollars this year, and you invest 10 percent, which is the recommended minimum, of your salary in the 401(k) plan for your company, then you will be investing $5,000 this year. In the eyes of the IRS, you actually only earned $45,000 this year because of your $5,000 10 percent contribution. What this means is when you were paying your federal taxes come April, you can save as much as $1,250 on your federal taxes, and that is not even including state benefits which will also mean a significant savings. As you can see, putting money away in your 401(k) plan is actually an excellent way for you to plan for your future retirement while simultaneously saving yourself on your current tax billet the same time. Depending on your tax bracket, your tax savings may actually be even higher.
So is there a catch?
Of course there is a catch, because there always is a catch and there is no such thing as free money. While you may be avoiding taxation for the current tax year by contributing to your 401(k) plan, you cannot avoid this taxation forever. Instead, your earnings and your contributions are going to be taxed as if they were regular income when you retire and withdraw them. Additionally, if you withdraw money from this account before you reach the age of 59 and a half years old, there is a 10 percent penalty that you will have to incur as well. Your 401(k) plan is meant for nothing more than to be a long term vehicle for savings, and it is vital that you treat it as such in order to get the most out of it.
Photo Credits: Jeremy Brooks
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