GETTING THE MOST OUT OF YOUR 401K
Many people don't realize what a great tax tool their 401k plan can be. And while we all look forward to what we hope will be a comfortable retirement-maybe even an early retirement-most workers still do not fully take advantage of the 401k offered by their employer. Fortunately there are many ways we can battle the IRS, keep more of our hard-earned money in our own pockets, and prepare for a comfortable retirement.
Participate
While it may sound oversimplified, the first step to maximizing your 401k plan is to participate. Surprisingly, although most companies offer 401k's (or a similar type of retirement plan), only about 75% of all employees eligible to take part in their employer's 401k plan actually do so. Contributions are made by way of a pre-tax payroll deduction; therefore, the bite taken out of your paycheck is less painful than you may initially think. Considering the effect of both federal and state income taxes, for every $100 you put into your 401k, you can save roughly $25 to $40 in taxes, depending on your tax bracket. Your 401k contributions will reduce your federal and state taxable income, although unfortunately not what will be deducted from your paycheck for Social Security taxes. However, the potential an employee's 401k participation can have in lowering their taxable income can be very important for someone who is "on the brink" of qualifying for a Roth IRA. Many couples earning around $150,000 to $160,000 (or single filers earning about $95,000) may not normally be eligible to contribute to a Roth IRA. But if they participate in their company's 401k with pre-tax payroll deductions, they may be able to reduce their taxable income enough to be under the limit to qualify for a Roth. Getting tax-free earnings on the investments in their Roth IRA then results in even greater tax savings down the road.
Get the Match
In most 401k plans, the employer will match your contributions 50 cents on the dollar, and in some cases, will even match dollar for dollar up to a certain percentage of your income. If you do not contribute enough to get the match, it's as if you are turning away free money. Yet only about half of today's employees contribute enough to receive a matching contribution from their company. Consider this: if you put in 3% of your compensation, and your employer puts in 3%, you have instantly made a 100% return on your investment, no matter what the stock market is doing! It is critical to at least contribute what your company will match, even on the tightest of budgets.
Start Saving Early
Ever heard of that little word "compounding?" It cannot be emphasized enough what a difference compounding makes on your investments over the long run. To delay saving for retirement can be very expensive. If you are 25 years old and want to retire at age 65, by saving $75 per month with an 8% return, you will have roughly $250,000 when you retire. If you wait until age 35 to start saving, you will need to save around $175 per month to have the same amount in the bank. Waiting yet another 10 years is extremely costly. At that point you will need to save about $425 per month. The moral of the story: if you don't start early enough, you can easily fall short of your retirement income needs. Needless to say, any goals of an early retirement will be completely out of the question.
Don't Cash It Out
If you leave your employer, the worst thing you can do is take the money out of your 401k and spend it. All of your gains will disappear, and the IRS will tax you on the withdrawal. If you are under age 59 ½, the IRS will also hit you with a 10% early withdrawal penalty. Depending on your tax bracket, you could lose about half of your 401k to taxes and penalty. So what should you do with it? Some plans will allow you to keep the money in the 401k. Others may give you the option of either leaving it in the plan or rolling it over to an IRA, which is not taxable or subject to penalty, and allows you to keep the money growing tax-deferred with many different investment options.
What about taking a loan from your 401k? It is important to remember that it is not in your best interest to use the loan provision your 401k might offer as a revolving line of credit. Loans are especially dangerous if you leave the company or it goes out of business, and you have to either quickly pay off a large loan balance or be subject to tax and penalty on it as if it had been a premature withdrawal. The only exception would be for things like medical emergencies. Most 401k plans allow for "hardship withdrawals" for expenses like college tuition, or to either get into a home or to keep a home in the event of severe financial difficulties. Using money in your retirement plan should only be considered as a last resort. Again, using the money early will only delay your retirement goal or cause you to fall short of the income you need when you do retire.
Hopefully, when you do retire and start using the money from your 401k, you will be in a lower tax bracket. This strategy may really play out well for almost all of us if the new, reduced tax rates enacted by the new administration stay intact.
