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401K plan - The Key to Retirement Planning

401K Plan If you already have a 401k plan in place, you're lucky. It is probably your most valuable retirement planning option.

A 401(k) plan has the potential to make you financially independent by the time you retire.

If you are wondering how, here are three strong reasons. A 401(k) plan offers:

  • Tax-deferred growth
  • An up-front tax deduction
  • An automatic savings benefit

The biggest benefit from enrolling in a 401(k) plan is tax-deferred growth.

These days, fixed-benefit pension plans are rapidly losing their value. Your Social Security is probably not going to be enough to live on.

You really have no choice but to make sure you take control of your own retirement planning. Let's look at how to enroll in a 401(k) plan.

Enrolling in a 401k plan

It's possible that your employer has already enrolled you in the company's 401k plan. With a company plan, you can decide how much you want to save and also make your own investment choices. Don't worry - any decisions you make now are not carved in stone. You can always go back and make different choices in a 401(k) investment plan.

Here are the basics of a 401(k) plan:

  • In order to participate in a 401(k) plan, you must be employed.
  • Your employer must also make a contribution to the plan.
  • You cannot create a 401(k) on your own, unlike an Individual Retirement Arrangement (or Account), or IRA, plan, which you can set up on your own.
  • 401ks are not available to self-employed individuals, although there are several other options from which they can choose.

But What If You Switch Jobs?

This is a very good question. When you leave an employer, you can always cash out your 401k, but this is a bad idea because you have immediate tax consequences. Instead, you might consider a 401k rollover into an IRA or to your new employer's 401(k) plan. A rollover just moves your investment from one retirement plan to another. The biggest advantage of a 401(k) rollover is that it is tax-free!

You can also choose between rolling over into a new 401k or into a Roth IRA, which also carries tax benefits. If you are comparing a 401k to a Roth IRA, remember that both are great retirement investment choices. But, there are basic differences between the two.

In a Roth IRA, you contribute after-tax dollars, which you then withdraw tax-free after retirement. In a 401(k) plan, you invest pre-tax dollars and then pay tax when you withdraw the money after retirement. It's a good idea to consult a financial planner to understand more about these investment instruments.

Are There 401k Contribution Limits?

The amount of money you can contribute to your 401k does carry a maximum contribution limit that varies by year and age. Your employer may have limits on your contribution, too.

Tax Implications of Your 401k plan

Each time you contribute to your 401(k) plan, your taxable income becomes lower. For instance, if you are in the 25 percent tax bracket and you contribute $200 to your 401(k) plan, you will save $50 in taxes, or 25 percent of $200. Your 401k balance goes up by $200, but your income is only reduced by $150 because of the $50 tax savings. But remember - the amount you pay in FICA and unemployment taxes does not change, regardless of your 401k contribution.

Tax-Deferred Growth - The Highlight of Your 401k plan

Your contributions to your 401k plan are tax-deferred. This means that you do not have to pay taxes on the income that you put into the account.

Don't worry - this is approved by the IRS! In fact, until you start to withdraw money from your 401k plan, you do not have to think about taxes on the money you have contributed to it.

You can begin to withdraw money from your 401k without penalty as early as age 59 1/2. You are not required to withdraw it, however, until you're 70 1/2. You can always withdraw the money earlier, but you'll have to pay a tax penalty.

As far as contributions to your 401k, you may start at any time, whether you plan to retire in five years or 35 years. Obviously, the earlier you start, the bigger your tax-deferred savings will be when you retire. If you get a head start, you'll be able to look forward to a substantial amount in your 401k plan.

 

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