401K LessonThe 401k is a form of investing for your retirement. Usually companies set up the 401K plan and allow employees to contribute up to 15% of their salary. You can choose to have the money taken from your check before taxes or after taxes. Investing the money before taxes helps you because you get the full benefit of your money before the IRS taxes you. The company will usually match what you put in up to 6% at .50 on the dollar. If you put in $500 the company will give you $250. That's an amazing return on your money, better than most investments. 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 you shouldn't have to pay it back because when you retire you should be in a lower tax bracket. Also you will earn interest on that $4.20. 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.
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