Investing 101 - What is a 401k?
The 401(k) plan was created by congress in 1978 as a way for individuals to save for their own retirement on a pre-tax basis.
In an era where traditional pension plans were already shrinking if not disappearing altogether, there was a perceived need for a sort of saving vehicle that would encourage workers to take control of their own retirement instead of relying on government and corporate largesse.
As it turns out, the 401(k) was simultaneously one of the very best and very worst things that could have happened to American workers.
What Is A 401(k)? In essence, a 401(k) is an investment account with deferred tax treatment.
That is, every dollar you save in a 401(k) today reduces this year's tax liability by the same amount.
For example, say you earn $50,000 per year and invest the recommended minimum of 10% of your salary in your company's 401(k) plan, which comes out to $5,000.
In the IRS's eyes your actual taxable income this year is only $45,000 because of your contribution ($50,000 gross salary minus your $5,000 401k contribution).
This would lead to a significant tax savings of $1,250 on your federal tax return, and that doesn't even include any state benefits! As you can see, saving in your 401(k) is an excellent way to reduce your current tax bill and save for retirement at the same time.
Additionally, the tax savings become even greater the higher your tax bracket.
What's The Catch? Of course, there's always a catch.
While you avoid taxation in the current tax year for 401(k) contributions, you don't avoid them forever.
Instead, your contributions and earnings will be taxed as regular income when you withdraw them in retirement.
Additionally, there is a 10% penalty for withdrawing from your account before you are 59 1/2 years old.
Your 401k is truly meant as a long-term savings vehicle and these penalties exist in order to deter you from raiding your own retirement accounts.
In an era where traditional pension plans were already shrinking if not disappearing altogether, there was a perceived need for a sort of saving vehicle that would encourage workers to take control of their own retirement instead of relying on government and corporate largesse.
As it turns out, the 401(k) was simultaneously one of the very best and very worst things that could have happened to American workers.
What Is A 401(k)? In essence, a 401(k) is an investment account with deferred tax treatment.
That is, every dollar you save in a 401(k) today reduces this year's tax liability by the same amount.
For example, say you earn $50,000 per year and invest the recommended minimum of 10% of your salary in your company's 401(k) plan, which comes out to $5,000.
In the IRS's eyes your actual taxable income this year is only $45,000 because of your contribution ($50,000 gross salary minus your $5,000 401k contribution).
This would lead to a significant tax savings of $1,250 on your federal tax return, and that doesn't even include any state benefits! As you can see, saving in your 401(k) is an excellent way to reduce your current tax bill and save for retirement at the same time.
Additionally, the tax savings become even greater the higher your tax bracket.
What's The Catch? Of course, there's always a catch.
While you avoid taxation in the current tax year for 401(k) contributions, you don't avoid them forever.
Instead, your contributions and earnings will be taxed as regular income when you withdraw them in retirement.
Additionally, there is a 10% penalty for withdrawing from your account before you are 59 1/2 years old.
Your 401k is truly meant as a long-term savings vehicle and these penalties exist in order to deter you from raiding your own retirement accounts.
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