As well discuss below, 401(k)s offer two key advantages. First, the money is sheltered from taxes, which means that more of your investment returns go to you rather than Uncle Sam. Second, many employers match employee contributions, giving you an extra financial incentive to participate.
But theres a catch: you can only invest in a 401(k) if you work for an employer that offers one. According to the Labor Department, 55 percent of US workers had access to defined-contribution plans (a category that includes 401(k)s) as of March 2013, and of those, 69 percent participated.
The 401(k) program is designed for private, for-profit employers. Other types of employers offer similar plans. For example, non-profit organizations can offer a similar plan known as a 403(b)s. While this article focuses on 401(k)s, most of the principles laid out here apply as well to other types of employer-sponsored retirement programs. such as 403(b)s. (In addition, this article focuses on traditional 401(k)s, which take money out of your paycheck pre-tax; Roth 401(k)s, which are far more rarely used, take the money out post-tax.)2) Why should I put my money in a 401(k)?
If you have access to a 401(k) -- and particularly if you dont have another vehicle for retirement savings -- putting your money into a 401(k) is a great idea for two broad reasons.
One is taxes. One big draw of a 401(k) is that it allows you to start saving your money without paying taxes on it. Yes, youll be taxed when you pull the money out, but in the meantime your earnings wont be taxed.
This makes a 401(k) a better approach than putting your savings into a normal, taxable investment account. These accounts do give you the flexibility to take the money out whenever you want. But because you have to pay taxes on the original savings and also on any investment earnings, your total tax bill will be higher, and youll wind up with less money when it comes time to retire.
401(k) plans also make it easier to save. Because they automatically invest money from your paycheck, they allow you to save up for retirement without really thinking about it. Since a portion of your paycheck never touches your bank account to begin with, theres not the temptation to spend it. A 401(k) plan works on autopilot: youre saving constantly, without ever having to think about it.
This is important because compounding interest can dramatically increase the value of your savings. Each year, you earn money not only on your original savings, but on money you earned in previous years. The result: if you keep your money invested for multiple decades, you can wind up with vastly more money than your original investment. The chart below illustrates this nicely -- saving early and often is the key to a comfortable retirement.