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401K Lesson
Live It Up Without Outliving Your Money!: Getting the Most From Your Investments in Retirement
If you put in $500 the company will give you $250. That's an amazing return on your money, better than most investments and better than most pension plans. Investing your money this way is great because money that you would normally be paying to the IRS is sitting in your account earning interest. I know it can be tough when you are first starting out but if you just invest 3% to start it's better than investing nothing and as you get pay increases you can put a part of the increase into the 401K plan until you reach 15%. If you are earning $500 a week and are in the 28% tax bracket and you don't invest in the plan you will pay $140.00 in taxes. However, if you invest 3% ($15.00) of that $500.00 in a 401K plan you would only pay $135.80. Therefore, your 3% investment is only costing you $10.80 but you are investing $15.00. In effect the IRS is paying $4.20 on your behalf and on top of that the company is going to give you $7.50. Ok so you invested in effect $10.80 and now you have $23.00 that's 108% return on your money. I don't know about you but I don't know a lot of places where you can get this kind of a return on your money. If you do this right and leave the money in the plan and let it grow you shouldn't have to pay back the tax money because when you retire you should be in a lower tax bracket. Also you will earn interest on all your money. The following is an example:
In effect you are only spending 2.04% to invest in yourself. The truth is you can't afford not to invest in your future. The beauty of the plan is your money earns interest tax free causing it to grow faster than most other investments. You would have to pay capital gains tax each year on most other investments thus reducing your overall return. The return that you get in this type of investment is phenomenal because of the compounding of the interest and the fact that you don't have to pay capital gains tax on it until you retire. The rule of thumb you can use to figure out when your money will double is called the rule of 72. To figure out when your money will double you start with 72 and divide it by the interest rate that you are earning. For example if you invest $5000 and you are earning 10% interest the formula would be; 72/10=7.2 years. In 7.2 years you would have $10,000. You need to understand that this is truly a retirement plan and as such your money is tied up until retirement with the exception of a few special circumstances such as to pay for education, your primary home, or a hardship such as a serious illness (check with your tax preparer). If you withdraw money before you are 59 1/2 you will have to pay a 10% penalty as well as normal taxes on the withdrawal. I strongly urge you to do everything you can to avoid a withdrawal because you give back most of the benefit you gained from investing in the 401K. Some plans will allow you to take out a loan against your funds in the plan but there are rules that have to be followed. The loan generally has to be paid back within five years and if you leave the company you could potentially have to pay the money back in as little as 60 days. Again I urge you to use this type of loan as a last resort because your earnings in the fund are much greater than the interest you will be paying yourself when you pay it back. I personally like the 401K better than a pension plan because I think you have more input than you do in a pension plan. Some pension plans don’t require you to make a contribution so on the surface they may seem better because you aren’t contributing but you really need to look at the long term return. However, usually when you don’t have to make a contribution to a pension plan it simply means your income is reduced by this amount so in the long run the contribution amount is about the same in both plans. Again in my opinion you have more of a choice in a 401k than you do in a pension plan. Another option for retirement is an Annuity. I discuss the annuity in detail in the Annuity Lesson but I just want to mention that an annuity is a form of retirement saving. An annuity is a form of insurance that pays the annuitant a series of payments for a specified time based on the choice you make either when purchasing the annuity or at the time the payments are scheduled to start.
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