When it comes to retirement planning, perhaps the most important step is to take advantage of your employer’s 401k plan.
The basics:
The 401k is named after an obscure section of the federal tax code. It allows you to set aside dollars on a pre-tax basis into an account for retirement.
Tax-deferred contributions:
So, lets say you make $1,000 a week and contribute 5% of your pay into your 401k. This comes out to $50 a week. But since it’s taken out pre-tax, the net effect on your take home pay is only $42.50 (if you’re in the 15% marginal tax bracket). This is because that $50 contribution lowers your taxable income. Now you can’t avoid paying taxes on this entirely, but you won’t have to pay them until you withdraw funds at retirement.
Employer match:
One of the best features of the 401k is that the majority of companies match a portion of your contribution. For example, my employer matches my contribution up to 4% of my salary. In other words if I contribute 4% of my salary, the company kicks in another 4%. This is essentially free money from my employer. I know that not all employers have a match and that not all matches are that generous, but every little bit helps.
Automatic investing:
Another great feature of the 401k is that contributions are automatic. You don’t have to consciously decide to contribute every payday. We all know that it’s a lot easier to spend money than it is to save it. With automatic contributions you can make sure that you are investing regularly. And what’s better is that after a while you get used to the size of your paycheck. You’re a lot less likely to think, “My paycheck is $42.50 less” after a month or two of regular contributions.
The power of time:
The earlier you start investing, the more you’ll have for retirement. This idea is intuitive to most people. People understand that they’ll have more by starting earlier. If I invest $5,000 a year for 20 years it equals $100,000. If I invest $5,000 a year for 30 years it equals $150,000. But there’s more to investing than just your contributions. No, it’s not magic… It’s compound interest, and we’ll explore that in the next post.
