Now, what is a 401(k) and why is it so important to have one? Simply put, a 401(k) is an employer-sponsored retirement savings plan -- or an account your employer sets up for you with an investment company to make automatic deposits right from your pay. The dollars that are deposited into the account increase in value over a long period of time, tax deferred.
What does tax deferred mean? Tax deferred means your money can grow in the account and you do not have to pay taxes on that money until you withdraw from the account. (We’ll discuss withdrawals in a later blog.) How come you don’t pay taxes on that money until later, you ask? Because the money being deposited into the account through your payroll is made with before tax dollars, or gross pay. For example, if you were to look at your paystub you would see something like this:
40 hours at $10.00 = $400.00
401(k) contribution = $25.00
Total taxable income = $375.00
Federal taxes = $x
State taxes = $y
FICA = $z
Your take-home pay = $375.00 – all taxes
If you notice, the contributions are deducted from your paycheck before taxes are deducted from your income. Contributing to your 401(k) allows you to pay less in taxes today. This means you pay taxes on less money than if you did not contribute to a 401(k). The more you make in contributions, the fewer taxes to be paid. These contributions add up over time, turning into a larger amount when you need the money later.
Here’s another example. Sally makes $50,000 per year before taxes. She decides to contribute $10,000 to her 401(k), thus paying taxes only on $40,000 of income.
According to the IRS, employees can contribute up to $17,500 for those under the age of 50 for the year 2013. Employees over the age of 50 can make additional catch up contributions in the amount of $5,500. This is to help older employees who are closer to retirement save more money.
So what happens to that money in the 401(k) account? How does it turn into enough to live on during retirement? The best way to substantially increase the value of your account is to invest your money.
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