Over the years, you’ve often heard how important it is to invest in the 401(k) plan at your workplace, but what is the big deal with a 401(k) anyway?
There are significant benefits of taking advantage of your 401(k). The first is the ability to contribute to your retirement before income taxes are withheld. Known as pre-tax contributions, these contributions come from your “gross” pay instead of your “net”, so they go into your retirement account before Uncle Sam gets his cut. This immediate tax deduction could bring the taxable income of someone making $40,000 per year down to $36,000 if they contribute 10% of their pay to their 401(k) plan.
Instead, taxes are only paid on the money you withdraw from your account in retirement. The benefit of this tax-deferral is based on the idea that the majority of us will make less in retirement than we do while we are working. In other words, investing in your 401(k) account allows you to defer the taxes to a later point in your life when your tax bracket may be lower. The tax treatment of your 401(k) earnings is a benefit as well. In other taxable investment or savings accounts, any realized interest or gains are taxed at a capital gains rate each year. In a 401(k) account, the taxes on earnings are also deferred.
This deferral of taxation also enhances growth through compounding. Compounding is the ability of an investment to increase exponentially due to earnings being generated on both principal and prior accumulated earnings. However, when you invest in your 401(k), you are not only generating earnings on your principal and accumulated earnings, but you are also generating earnings on your employer’s contributions and on the money that would have otherwise been withdrawn to pay taxes had taxes not been deferred.
One of the more underrated benefits of a 401(k) plan is the ability to pay yourself first. Avoiding Uncle Sam is one thing, but avoiding ourselves can sometimes be an even bigger benefit. The advantage of setting up an automatic payroll deduction for your 401(k) deferral means you don’t have access to that money so the savings are automatic. Your wants and needs will always exceed your available cash flow, so saving money through a payroll deduction plan at work or an automatic withdrawal system is the most effective method to accumulate wealth.
Saving money is a crucial component of your financial plan, and because of its many benefits, the employer-sponsored 401(k) is one of the best savings vehicles available. In the next article, we will review the other benefits of taking advantage of your 401(k) plan, such as an employer match, as well as alternatives for saving if a 401(k) is not available.
Next time: The Perks of Investing in Your 401(k) Plan – Part II
Peter C. Golotko, CPA/PFS, MBA is principal of CPS Investment Advisors. Nolen B. Bailey, CRPS®, ARPC, Director of Retirement Plan Services, is a contributing author of this article.