What is a 401k plan?


Very simply put, a 401k plan is a company sponsored retirement tool. More or less, your company will allow you to deduct a portion of your wages to be invested. More important, your company will match a portion of what you invest and this is free money to you.

Let me show you a quick example of why pays to invest, rather than just save money: Below, I will talk about two brothers, one whom chooses not to invest through his 401k plan, rather into savings after he gets his paycheck – and the other whom knows he will have more money than his brother at the end of the day by investing pre-tax:

Billy Bob makes $30,000 a year, but invests no money, rather he saves about $1,500 a year from his paychecks. His taxable income would be $30,000. Let’s say his tax rate is 25%. He would pay about $7,500 in taxes, and his take home pay for the year would be $22,500 (30,000 X .25 = 7,500 and 30,000 – 7,500 = 22,500). Billy Bob then puts aside 1,500 in savings, for a net of $21,000 for living expenses at the end of the year.

Freddy, Billy Bob’s brother, makes the same amount of $30,000 per year, however, Freddy participates in his companies’ 401k plan, and he contributes 5% of his wages to be invested. So, Freddy’s taxable income would be $30,000 less 5% or $1,500 (30,000 x.05 = 1,500 and 30,000 – 1,500 = 28,500) or $28,500. Taxed at the same 25%, Freddy would pay $7,125 in taxes (28,500 X .25 = 7,125). Freddy’s net pay for the year after investing would be $21,375.

The two brothers would have both set aside the same amount, however, Freddy would actually have $375 more in his pocket at the end of the year than Billy Bob (not to mention whatever amount his company matched in addition to what he invested! Billy Bob thought he was doing fine saving on his own, but actually he was hurting himself!

Do you believe me now? It truly pays to invest, especially when your company matches what you put in for FREE!

Now, some are still wondering or swearing at me: “What about the taxes on the 401k investments?” Yes, it is true you will have to pay these taxes some day. The above example shows the man chose to have his money deducted from his pay and invested pre-tax (in other words, the IRS will allow you the option, pay taxes now or later). The key here is, for most, you would rather pay taxes later when your income is much lower (as it is when you retire), because you will be in a much lower tax bracket by then because you will be living off of investment income. Not to mention – you get the benefit of having all of those dollars you invested making you money instead of making the government money. If given the option however, and say your investing through an IRA, you’re better off choosing a Roth IRA, and investing after tax dollars. I’ll explain that later, don’t worry.

Another important point and reason to invest pretax is that there is the potential that by investing you would even lower the tax bracket you are in, according to your taxable income, further raising your take home pay.

Per Wikipedia, The term “401(k)” has no intrinsic meaning; it is a reference to a specific provision of the U.S. Internal Revenue Code section 401. However the term has become so well-known (it is almost a “brand”) that some other nations use it as a generic term to describe analogous legislation. E.g., in October 2001, Japan adopted legislation allowing the creation of “Japan-version 401(k)” accounts even though no provision of the relevant Japanese codes is in fact called “section 401(k).” India, Hong Kong, and Singapore refer to their equivalents of the U.S. 401(k) plan as Provident Funds. Egypt and Lebanon have a similarly structured retirement fund, and Israel has its own retirement fund.

Now, hopefully you see the benefits of investing versus saving, but that’s just the tip of the iceberg. Continue on with the lessons and you’ll be repeating my mantra by the end, “Would you rather work for money, or have money work for you?” I’m not sure where I heard that or who said it, but it’s certainly something to ponder. Some people just want to work til they’re 80, I on the other hand don’t and won’t. By preparing for my future and teaching you, you can join the folks who work hard and retire early by simply retirement planning and investing. Check out all of my lessons and articles for help in making sense of setting up your investments and help in selecting what investments are best for you.

The next lesson is “Learn about the importance of Compound Interest and how it can make you money, click here to move on.

Don’t have time to carry on now? Come back at your leisure, but don’t wait too long, every dollar wasted is a dollar not working for you.  Also, consider signing up for my daily updates sent right to your in-box. Don’t worry, I hate spammers too.

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