401(k) Plan Advantages
You could spend up to one third of your life in retirement. Are you financially prepared?
According to a 2006 U.S. government report, Social Security payments currently cover just 39 percent of the income you'll need for retirement - and probably less in the future. You'll have to come up with the other 61 percent through an employer-sponsored pension plan, personal savings, or both.
One of the best ways to save for retirement is through a 401(k) plan, if you have this benefit available from your employer. The amount you contribute to your 401(k) comes out before taxes – meaning you have more to contribute than if you waited to invest after taxes are deducted. Your money grows tax-deferred, so you don't pay taxes on your contributions or earned interest until you begin making withdrawals.
Compared to other ways to save for your retirement, the 401(k) plan has many advantages. Here are 10 reasons to participate in a 401(k) plan:
1. Deductions are easy and automatic.
Your 401(k) contributions are automatically deducted from your paycheck, providing a disciplined approach to saving for your future. Your 401(k) plan may allow you to contribute a specific dollar amount or a percentage of pay. We consider contributing a percentage of pay; that way, when you receive a raise, you are giving your plan a raise.
2. Your employer match is free money.
If your employer offers a matching contribution, do not pass up free money. Make sure you are contributing at least the maximum amount your employer matches.
3. 401(k) contributions offer great tax advantages.
First, your 401(k) contributions are made before income taxes are deducted from your paycheck thus reducing your taxable income. Second, your money grows tax-deferred. That means you do not have to pay taxes on the growth in your account until you withdraw it. This allows your savings to grow much faster.
4. The power of compounding earns you more interest over time.
Compounding is what makes a 401(k) plan such a powerful savings tool. Your principal earns interest that earns interest, and that interest earns interest. The longer your money is invested, the more compounding can work for you.
5. Dollar cost averaging is a smart investing strategy.
401(k) investors use this strategy by default. Instead of waiting for the bottom price at which to buy, you consistently use the same amount of money to buy assets over time. When prices are high, you buy fewer shares. However, when prices are low, you buy more shares. This tends to lower the average cost of all of your shares. Keep in mind, for dollar cost averaging to work, you need to invest regularly and consider your ability to continue purchases during low price levels.
6. You can contribute more to a 401(k) than to an IRA.
In 2007, depending on your situation, federal law permits 401(k) participants to contribute up to $15,500 tax-deferred, or $20,500 if they are 50 or older. Comparatively, depending on your situation, you are only allowed to save up to $4,000 in an IRA in 2007, or $5,000 if you are 50 or older. Your contributions to an IRA may not be tax deductible if you participate in a 401(k) plan, depending on your salary.
7. It's a convenient way to create a professionally managed, diversified portfolio.
Earning money in the market is a tough, full-time job. One key advantage 401(k) plans offer is the professional money management of the investments available to you in your plan.
8. Loans and hardship withdrawals may let you withdraw money in an emergency.
Many plans offer loans, which you repay, or hardship withdrawals, which you don't, as a way of getting your money out in an emergency. However, since saving for retirement is the plan's primary purpose, there are some restrictions. It is best to investigate all other options first.
9. You can take your contributions when you change jobs.
Your 401(k) contributions and related earnings are immediately 100% vested, meaning you own them. If you leave your employer, you can roll your contributions into a new plan. This simple process will keep your savings tax-deferred. However, employer contributions, if any, may be subject to vesting requirements.
10. Social Security will not be enough.
It's widely accepted that Social Security is only meant to provide a modest percentage of your retirement income. Financial planners generally say you will need between 70 and 80 percent of your pre-retirement income to live comfortably in retirement. Where is that money going to come from? A 401(k) plan could be a good source of supplemental income.
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