Although this retirement plan, called the 401(k), may not sound exciting or trend-setting to us currently – it is most often the least fancy element of your pension – whichever form it takes, 401(k) plans are generating normal income earners into millionaires through sheer, compounding wealth. The plan allows its participants to invest their earnings using pre-tax deductions taken out once they’ve been paid. There isn’t any requirement to use immediate trading or to involve themselves in crypto drama, nor do participants need to do anything other than be patient and take advantage of automated allocation systems throughout their employment period.
Usually when you start working for a company, during your onboarding, the HR representative will inform you of your retirement savings plan and provide you with a simple form to fill out. You will complete this form and forget about it until the end of time. In this case, that boring process may have been one of the biggest financial opportunities ever presented to you.
Think about it this way, if you were able to spend your paychecks before you receive them, then there wouldn’t be any temptation to spend your money on non-essentials. Once again, because of the beauty of a 401(k), there will never be a reason to say, “I’ll save for this later.” In essence, the 401(k) eliminates any guesswork.
Just to go back to the basics, a 401(k), according to U.S. Federal Tax Law, is essentially an investment vehicle that allows each participant to save for their retirement. Participants will contribute to the 401(k) plan while they are employed by an employer with the specific goal of creating long-term investment capital available when they are ready to retire. All of the tax benefits associated with 401(k) and IRA accounts are allowed because they are so boring.
When you deposit money into a 401(k), you do not pay income taxes on that portion of your paycheck immediately. As a result, the amount you made on your paycheck will show as being lower since you did not have all of the amount reported on your tax return (because of the contribution), thus lower taxes today.
Employers may contribute additional funds to your 401(k), often called a “Match” program. When you put money into your 401(k), your employer matches some of your contributions, whether dollar-for-dollar, half-of-a-dollar for each dollar, or some percentage. The actual calculation varies from one employer to another; however, it is very simple: If you are not aware of this, you are giving up some of the “Free Money.”
When you deposit money into a 401(k) plan, it is not just sitting there; it’s being invested. Typically, the investments are made through mutual funds comprised of stocks and bonds. You won’t have complete freedom of selection when deciding where to invest; however, you will have enough options. For those who do not wish to think about it at all, “Target Date Funds” are available. Simply choose a target date near your anticipated retirement date, and the target fund will automatically adjust its asset allocation according to the time remaining until your anticipated retirement date.
Picture this: 25-30 years in the future. Now we see the “boring” montage portion of our film-without action sequences or cool stunts-just steady contributions, the ebb and flow of the market, and the compounding of returns. Then one day you log on and find that you are sitting on a 6 or 7 figure account! And all without buying a lottery ticket!
When you reach retirement (age 59 1/2), you can begin withdrawing funds from your account. At this point, any amounts withdrawn will be taxed as income. However, for the majority of retirees who make less than when they were employed, this means they will likely pay a lower tax rate!
If you attempt to withdraw funds too soon, the government will penalize you heavily! So while it isn’t “illegal,” it will definitely hurt! And the government wants that hurt to be felt. The purpose of this structure is to prevent you from making impulsive decisions that may negatively affect your future selves!
The big question everyone has sometime in their life is, “Should I use my employer’s 401K?” The answer is surprisingly straightforward: it depends. If your employer matches your contributions, there’s no question—you should contribute enough to get every single dollar in free money available.
However, when there is no match, the answer becomes a bit more complicated than that. Other types of retirement accounts may offer more investment options and fewer fees than most 401K accounts. But you also need to consider how easy and convenient a complete automated system that works behind the scenes can be, as opposed to trying to manage a so-called perfect plan that you’re never going to keep up with.
The beauty of a 401K doesn’t come from being trendy, exciting or complex. The beauty of a 401K is that you set it up once, and you just need to let it do its thing for many years down the road. You may look back at what you thought was the most boring decision you’ve ever made and realize that it was the wisest.
