“Compound interest is the 8th wonder of the world. He who understands it earns it, he who doesn’t pays it.”~ Albert Einstein
Most everyone has heard of a 401(k) plan. If you’re an employee of a company or even if you own your own business and work with a financial planner, you probably have one. But what does having a 401(k) plan actually do for you?
For starters, they are the most common form of retirement plan. 401(k)’s are technically a “defined-contribution retirement plan.” But what on earth does that mean?
Defined-contribution is a fancy term the IRS uses to define the amount of money you can put into your 401(k) annually.
So, in 2019 you can contribute a total of $19,000 is the MAX amount you can put into the plan. Of course, you can put less in but you cannot go over that $19,000 mark.
Let’s step back for a second, what is a 401(k) plan exactly? If you go to the tax section 401 and the subsection “k” you can actually find all the rules about 401(k)’s. This includes information such as who you can put in the plan and who you can “discriminate” against.
Ok, obviously, discriminate is a scary word and it doesn’t mean discriminating against race, age, or anything like that. It’s a way of asking how many hours have you given to the company, how long you’ve worked there, etc. but the great thing about this; once you’re in you’re in.
You might be asking, “Why would I want to put money into a 401(k)?” The beauty of a 401(k), is it grows tax deferred until it’s withdrawn from the plan. Since you don’t pay tax it’s like you’re getting a tax free loan from the government.
You’re putting money in pre-tax and the longer it grows in the account, the more money you save in taxes. Eventually, as you take money out, you’ll get taxed.
So, let’s say you’re 30 years old and you set up your 401(k) plan. Once you start taking money out 40 years from now, you’ll start getting taxed on what you take out. However, up until this point you get yearly tax deductions on that money.
The thing about 401(k)’s is you don’t know how much you’ll accrue in 40 years from now. Despite this, that’s still a lot of time for money to compound in your favor.
Here’s the quick math:
Let’s assume your contribute $10,000 per year into your 401(k) plan and then assume you receive 7% annually. In 40 years, you would have a total of $2,146,088.
If you could only contribute $7,000 per year into an after tax investment account or a brokerage account, since you paid your tax first – 30%, after 40 years with a 7% annual interest rate, you would have a total of $1,502,259.
That’s a difference of over $600k!
As we know with the government there’s always a catch. Once you reach 70.5 years, there’s a minimum required distribution you must take based off the money you have in your account and your life expectancy.
Once you reach this age, if you don’t take money out you will be taxed 50% on the money you were supposed to take out for that year. That’s right. FIVE. ZERO.
For example, if you were supposed to take $10,000 out and you don’t, BOOM, that’s $5,000 Uncle Sam takes from your pocket. So mark your calendars!
Now that we’ve got the annoying government stuff out of the way, let’s discuss something good.
Many companies will offer to match the amount you contribute to your own 401(k). Talk to your financial planner or employer about this. You make a payment, your employer matches it. It’s free money and who doesn’t want that?!
Having a 401(k) is an extremely beneficial tool because you’re saving money and not getting taxed over that lengthy amount of time your money is growing tax deferred. It’s a great way to invest now and benefit later.