401 k Basics
An employer matched 401 (k) is considered a good retirement plans to take advantage of if it is offered. The problem is many people don’t use this tool because they simply don’t understand it. Let’s divulge right into it.
As with every retirement plan, or basically anything in life, you have pros and cons. One of the greatest benefits to this plan in particular is that you get “free money” from your employer. This free money is called an employer match or contribution. Employers are not required to match but many do so, especially in large companies. The maximum contributions for 2012 are as follows.
|Employee Contribution Limit||Employer Contribution Limit||Annual Maximum Contributions||Catch Up Contribution
(Age 50 and up)
The numbers above sound wonderful; however they are not the normal. There are companies out there that do generously match the employees pay, such as McDonald’s, but the majority does not. The average matching contribution is 50 cents for each dollar the employee contributes, up to 6 percent of their pay. Using this scenario the employee receives 3 percent of their pay. Even on the average the employee is earning ‘free money”, which is why the majority of financial consultants see a 401(k) as a common sense investment vehicle.
Aside from the matching benefit there is the tax reason this investment should be on everyone’s radar. Any money that you contribute to your 401(k) comes out of your check before taxes. This is a huge benefit because you are not taxed on this money; therefore overall you are paying less tax each pay period. You will be taxed on the money when you withdraw during retirement. However, odds are you will be in a lower income tax bracket; therefore you will pay less money in taxes.
Once the money is taken out it is put into mutual funds, bonds, money markets and other investment vehicles. So in essence you are contributing a portion of your check pre taxes, receiving a contribution from your employer just for contributing and then it is going into numerous investments so you have now accomplished the ultimate investor’s goal which is diversity.
This whole scenario sounds too good to be true, right? Well it is not, however I did mention in the beginning that there are pros and cons. Let’s now explore the cons. As with any retirement account the money you are contributing is intended for long term. If you choose to withdraw the funds before you are 59.5 years old you will pay a tax on it and also a 10% penalty fine to the IRS. So basically you will be taxed twice. Depending on how much money you are withdrawing that number can be steep.
The other main disadvantage to this investment option is that it is a risk. Keep in mind as we spoke about earlier your money is being put into different options, such as the stock market. If the investments do not perform well you risk losing money that you have invested. As with any financial decision please consult a professional to discuss your situation and see which retirement avenue would best suit your financial goals.