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Prepare for Retirement by Starting a 401(k) Plan

Employee Benefits
Article
07/17/2014

How do you envision your retirement years? Traveling? Enjoying leisure time with family and friends? Golfing, gardening, or enjoying another favorite pastime? Regardless of your goals, retirement requires money — almost certainly more than you think! But Social Security rarely provides what most people want or need, and pension plans are not as common as they once were. So if your employer sponsors a 401(k) retirement plan, seize the opportunity.

A 401(k) plan lets you save and invest a portion of your paycheck before taxes are taken out. Because you're saving with tax-deferred dollars, you don't pay federal or state income taxes on the money you save until you withdraw it, generally at retirement. At that time, you’ll likely be in a lower tax bracket than today. The interest on the money saved in the 401(k) grows tax-deferred.

401(k) plans (named for the applicable section of the U.S. tax code) first appeared in the 1980s as a supplement to pensions. Now, 401(k) plans are well established, but still underutilized.

How a 401(k) plan works

Many 401(k) plans allow you to choose how to invest your money. Most plans offer an array of investment vehicles: mutual funds comprised stocks, bonds, and money markets. Investment options carry levels of risk from conservative, with lower but more reliable interest gains, to risky, with potentially high return rates but also higher possibilities for losing money. Investment gurus often advise to diversify your money among stocks, bonds, and money markets to mitigate risk.

Usually, you must work for your company a certain amount of time before becoming eligible to enroll in the 401(k) plan. Contributions come out of your paycheck automatically, making it effortless. Many employers will match workers' 401(k) contributions up to a certain amount — often 3 to 6 percent of your salary. If you make $50,000 annually and defer 3 percent ($1,500) into your 401(k), your employer may match that up to another $1,500. Be sure to check the rules for contributions, including how much you can contribute each year. (In 2014, the IRS limits employee contributions to $17,500 annually, with employees over the age of 50 enjoying a higher limit, if the plan allows.) Matching funds, which become nonforfeitable when you've completed your company's vesting period, can really help your 401(k) account grow.

You may begin withdrawing your 401(k) funds as early as age 59½ depending on the plan’s provisions.

Compounding interest

Contributions to a 401(k) plan have the benefit of compounding interest: The interest you earn each year on your investment is added to your principal. Say you contribute $1,000 to your 401(k) — that's the principal. If you earn 10 percent interest a year, your balance would be $1,100 at the end of the first year, $1,210 at the end of the second year, $1,331 at the end of the third year, and so on. You can see that with continued annual contributions— coupled with employer matching funds — your 401(k) account can grow over time.

By maximizing the amount of money you can contribute to a 401(k) each year, you take full advantage of compounding interest, as well as employer matching funds.

Take-home benefit

Because you fund your 401(k) with pre-tax dollars, your taxable income declines. This table shows how a 401(k) increases the take-home pay of a worker who makes $35,000 annually. By reducing the tax burden, that individual keeps $472 more of their salary than if they saved that money in a conventional savings account.

 

Without 401(k)

With 401(k)

ANNUALIZED GROSS PAY

$35,000

$35,000

401(k)

0.00

-1,750

Taxable Pay

35,000

33,250

Federal Income Tax (27%)

-9,450

-8,978

FICA (7.65%)

-2,678

-2,678

Conventional Savings Account

-1,750

0.00

NET TAKE-HOME PAY

$21,122

$21,594

 

A smart retirement option

To review the many advantages of a 401(k) retirement plan:

  • You decide how to divide your money among the investments offered (in participant-directed plans).
  • Interest compounds, which may significantly increase your principal and the size of your investment.
  • Contributing pre-tax dollars increases your take-home pay.
  • Many employers will match your contributions up to a certain percentage of your investment.
  • You can contribute up to $17,500 a year to your account, plus an additional $5,500 in catch-up contributions for those over 50 (as of 2014).
  • Contributions made by your employer become yours, according to your plan's vesting schedule.

A 401(k) plan is a great way to use your current financial resources to fund a secure future.

 

This website contains articles posted for informational and educational value. Paychex is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, Paychex. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant.
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