In order to get into the basics of what a 401(k) is, a bit of background is necessary:
Employer-sponsored retirement plans tend to be grouped into two primary classifications: Defined Benefit (DB) and Defined Contribution (DC). In the former, the employer agrees to pay a set amount to retirees who are able to meet certain eligibility stipulations. This means the plan defines the benefit that is going to be received. Typically, a DB will pay a lifetime of monthly amounts (benefit) to the retirees who meet specific age and service criteria. These amounts are often directly correlated to the amount of service and the final average salary for that position. The sponsor (employer) also has the option to provide an alternative lump-sum, or “cash out” of the benefit entitlement. Until recently, DB was the main employer-sponsored retirement program being implemented.
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When it comes to DC plans, the plan is what defines the contributions that an employer is able to make, rather than the benefit that will be received upon retirement. The terminating employee receives the amount in a current or deferred lump, or annuity. Because the benefit is not defined in this plan, the retirement outcomes are unknown in advance.
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This brings us back to the topic at hand: The 401(k).
In 1978, section 401(k) of the Internal Revenue Code authorized the use of a new type of DC plan that allows for the employee to be able to make pre-tax contributions to the plan.
Simply put, a 401(k) is a way for the employee (That’s you!) to contribute money to an account, usually before tax. You are able to choose different plans and options that work best for you and fit into how you wish to invest your money. More often than not, your employer company will also contribute money to your plan. While your investments grow within the 401(k) account, you will not be paying any taxes on it.
So, I never have to pay taxes on my 401(k)??
Well, you do, but not until much later on. When it’s time to take the money out, you will then have to pay the standard income tax on that amount. However, you do not have to pay taxes on the money that you put in (contribute) in the year that you contribute it. This means, if your income is $60,000 and you put $10,000 into your 401(k) this year, your taxable income come Tax Day (April 15!) will be $50,000, not $60,000.
Why should I worry about it now?
This answer is always relevant, regardless of how long you have been accruing money! The sooner you start contributing to a 401(k) account, the more money you will end up gaining in the long run. This is because of compounded growth. You will earn profits on both the money you contribute and, after some time, on the returns from your initial investments.
Basically, your 401(k) money will start growing. . .and then growing some more. . .and then growing some more. The longer you let it grow, the more it will do so! The key to letting it grow really big is to give it time. That’s why it’s best to start as soon as you can.