A 401K or employer provided retirement plan is one of the biggest and easiest wealth building tools that many employed individuals have.
For many of us, we will not be able to rely on pensions or perhaps not even Social Security during our retirement so our retirement lifestyle is going to be solely dependent on our own ability to save and invest for our future – with a little help from our employers.
Below are four reasons why contributing to an employer provided retirement plan is a powerful tool that should be considered by every single person that has access to one:
Tax Advantaged Account
You may have access to either a traditional or Roth employer provided retirement plan.
A Traditional employer provided retirement account will operate as follows:
- It will be funded with pre-tax dollars. Meaning that before your earnings are taxed and deposited into your bank account, first a percentage of your earnings will go to your retirement account and then the difference will then be taxed and deposited to you.
- Your funds in the account will be invested into the investments of your choosing and will grow tax deferred. Meaning that the tax on the funds contributed into the account and any earnings within the account will be deferred until you distribute the funds from the account at a later date.
- Come time to withdraw the funds, you will then be taxed at ordinary income rates.
An interesting and attractive part of the Traditional 401K is that those pre-tax contributions actually lower your taxable income.
Let’s say you made $100,000 but contributed $20,000 to a Traditional 401K – only $80,000 of your income would be taxable in that year and thus reducing your current year tax bill.
A Roth employer provided retirement account will operate as follows:
- You will fund it with after tax dollars. Meaning that after your earnings are taxed, a percentage of that amount will then go to your retirement account and the remaining amount will be deposited into your bank account.
- The funds in the account will be invested into the investments of your choosing and any earnings within the account will continue to grow TAX FREE.
- You will be able to distribute the funds from the account after age 59 1/2 penalty and TAX FREE assuming it’s been 5 years since you have opened and contributed to the Roth account.
Employer Contributions
Employer contributions made directly to your employer provided retirement plan are part of your compensation. But for many employers, their contribution amount will rely solely on your contribution.
If you are in search of a job – it will be important to understand all the elements of your compensation and benefits provided to you by your employer. Employer contributions to your retirement account are part of that package.
If you are currently employed but aren’t contributing to your employer provided retirement account you need to be considering the money lost as a result of you not contributing and not taking advantage of that employer match. See below for an example:
Let’s say you make $100,000 per year and your employer matches 50% of your contributions, equal to up to 5% of your annual salary. In other words, over the course of the calendar year, the employer will contribute up to $5,000, so long as you contribute $10,000. $5,000 invested on an annual basis should not be ignored or deemed insignificant.
Some employers also have profit sharing plans. So in addition to their ongoing employer match, they may add a one-time additional contribution per year as a means to share profits with you or as an appreciation or recognition of your work or performance throughout the year.
Don’t let these funds slip away because you haven’t opened or prioritized contributing to your retirement account.
Automation & “Forced Savings”
The element of automation that is involved in employer provided retirement savings is the secret recipe to its success. Having money immediately withdrawn from your pay to fund your retirement without you having to consistently take action – that’s a beautiful thing.
You never see those funds hit your bank account and you learn to live on a little less as a result. That is a powerful habit to begin early on.
Between the automatic investing and the lack of easy access to these funds, I find it to be an incredibly powerful way to invest for your future. There is no additional effort or time required by you to continue to contribute and there is limited opportunity for you to take the funds out for whatever your heart desires. It’s meant for retirement and thus there may be penalties associated with distributing the funds prior to age 59 1/2.
The set it and forget it “forced savings” approach here will lead to meaningful results down the road.
Compounding Growth
Compounding growth is not specific to employer provided retirement accounts but investing, in general, will give your money the opportunity to grow over time.
For example;
In year 1, let’s say you invested $1,000 and it grew by 10%. You now have $1,100 in the account.
In year 2, you have $1,100 and again it grew by 10%. You now have $1,210 in the account.
Your money that you originally contributed has grown, and that growth is now growing. No additional investment – but more money in the account to have the potential to grow.
Imagine the impact that 30+ years of contributing to your retirement account along with its compounding growth will have on your retirement account and on your ability to live out the retirement lifestyle you want.
Prioritize Your Employer Provided Retirement Plan
Contributing, at a minimum up to the employer match and best case scenario up to the max contribution, to your retirement accounts should be up for consideration for any and all employees who have access to them and the means to be contributing.
And more than likely, unless you are currently contributing the max allowed to your account, I venture to bet that you could probably afford to contribute more…!
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