What is a 401k?

By | August 15, 2007

The average age of retirement for Americans is increasing rapidly. If you want to have any chance of enjoying your golden years in comfortable retirement, you need to start preparing now. A 401k is a great way to prepare for your future while reaping tax benefits now.

Purpose of a 401k

A 401k is designed to make it easy to save for retirement without having to invest it yourself. 401k funds are typically offered through employers or private financial planners. You can take a certain amount from your paycheck every week or month and have it immediately deposited into your 401k. Even better? The money you invest in a 401k is taken out before taxes.

The money you deposit in a 401k grows each year as your investments fluctuate. Your money is invested in a variety of stocks, bonds, and money market accounts. How aggressive your investments are depends on when you plan on retiring. The money can be retired without paying any additional taxes or fees when you are 59.5 years old.

Benefits of Opening a 401k

Besides just saving money for retirement, there are lots of other benefits to opening a 401k when you start a new job. Many employers match funds that you put into your 401k. You can put in up to 15% of your income into a 401k, unless your employer has a different limit. The amount your employer matches varies from company to company. They may match dollar for dollar what you invest up to 5% of your income. They may match 50% of what you match for your first 3%. When you qualify for a 401k, your company will give you more details.

Additionally, 401k funds are taken out before taxes. This decreases your tax burden, which may increase your refund or decrease the amount you pay in when you do taxes. If you are close to a lower tax bracket, putting enough money in your 401k can drop you down a bracket and save you tax money.

Early Withdrawals and Borrowing from a 401k

If you have a financial emergency or otherwise need to access your 401k funds, you can do so by borrowing from your 401k. However, there are penalties for doing so. You have to pay taxes on what you take out—so account for 25% or so to be taken out right off the top—plus a 10% penalty fee for however much you take out. These rules apply to any withdrawals made before the age of 59.5. There are many other rules to early withdrawals, and good sites can be a great resource in making your decisions.

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