How Your 401(k) Can Be The Best Investing Tool You've Ever Used

The 401(k) tax deferred retirement savings plan was established by the US government in 1981 to allow individual investors to save money for their own retirement. Money put into a 401(k) is taken from pre-tax income, and can be matched at various levels by an employer. Furthermore, all interest earned by a 401(k) is tax deferred.

While several pieces describe how important those three advantages are, or simply tell you how important they are, we're going to play with the numbers a bit to show you what we mean. To do this, we'll explain a couple of investing concepts, and it'll be handy if you have a pay stub to examine.

First, look at your pay stub from your last check. There were deductions taken out for federal income tax, and probably state income tax as well, plus FICA, Social Security and maybe a few other things as well. Take up the total of those deductions, and compare them to what you earned, pre-tax. It probably comes out at about 20 to 35% depending on your individual deduction schedules and what state you're in, and how much you earn.

That percentage is your "tax bite" – it's how much you get bit for every paycheck. When a 401(k) or a Roth IRA is part of the picture (and a few other programs, like the HCRA), the money that's put aside in that account is taken out before all other deductions. What that means to you is that it's effectively multiplied by an amount equal to your tax bite.

Let's assume you get $1,000 as a biweekly paycheck, and your normal tax bite is about 25%; this leaves you with a post-bite income of $750. Now, let's assume that, between your 401(k) and your HCRA, you're putting $200 of that check away. If it came out after taxes, you'd be getting $750 minus $200, and take home $550. Coming out before taxes, the numbers come out a bit differently. $1,000 minus $200 is $800. Your tax bite of 25% means that $200 of that $800 goes to taxes, leaving you $600 to spend. Even if you decided you could live off of $600 biweekly, and put that $150 into savings directly, you'd end up with $50 less each paycheck in savings. Effectively, by putting the money into savings before it gets bitten on by the tax man, you're multiplying it by 33% for the same take home funds.

Now, if all those numbers made your head spin, let's review it for you: Money put away into a savings plan from pre-tax income is more valuable than money put into a savings plan done with post tax income.

The next major advantage of a 401(k) is employer matching. In many ways, this is the most impressive advantage of 401(k)s. What this means that up to a certain percentage of your salary, for every dollar you put into a 401(k), your employer will put in a matching dollar. This may not seem like much, but consider this: In investing, there's a rule of thumb called the Rule of 72. This rule determines the amount of time it takes for an initial investment to double in value from constantly applied compound interest; to do so, take 72 and divide it by the interest rate (or rate of return) in percentage points; this tells you how many years it'll be to double the investment if no other money is added. Thus, for a 6% rate of return, the "doubling time" is 72/6=12 years. Compare that to employer matching, which doubles your money immediately – on pre-tax income, which has effectively been multiplied by anywhere from 20-33% already.

For the final benefit, money in 401(k) accounts accrues tax-deferred interest. What this means is that you don't pay taxes on the interest as it accrues, you pay taxes on the final lump sum when the account is closed. What this does is raise the effective rate of return on your investment while the funds are accumulating by roughly 25-30%, because you won't have to set aside a fraction of the investment income each year to pay taxes.

As a case in point, let's assume that your average amount of money in your 401(k) account for a given year is $80,000, and it's appreciating (increasing in value) by a healthy and respectable 8% per year. 8% of an average dollar value of $80,000 is 80,000 x 0.06 = 4,800, or $6,400. If that money weren't in the 401(k), the $6,400 would be considered taxable investment income, which has an average tax rate of 30% combined State and Federal combined, which means you'd get $6,400 * 0.70 = 4,480 added to your balance. Instead, the full $6,400 is added, and this effectively means that your 401(k) interest rate is higher for the purposes of compound appreciation.

Now, there are drawbacks to a 401(k) – first of all, you can't touch the money, barring a hardship withdrawal before the account matures. This means that it's NOT a fluid asset. You can't use your 401(k) to buy a house, for example. Nor can you use it to pay for your children's education, though there are similar plans to a 401(k) for both of those processes. If you withdraw the money before age 60, you will be socked with early withdrawal penalties that start at 10% and only get worse from there.

When you do make withdrawals on the account, you're going to have to pay all the deferred taxes on the income and interest; this can add up to quite a substantial sum of money; only 20% of your withdrawal will be withheld by the IRS, so there's a certain amount of accounting to do when you withdraw from your 401(k).

Finally, you have to stay with your current employer for the vesting period on your 401(k); this period ranges from 3 to 7 years depending on the 401(k) program, the size of your contribution and other factors. If you leave your employer before the vesting period is complete, a percentage of the matching contributions are refunded to your employer.