Wealth Building Lessons

One of the most common methods that people use to save for retirement is their company 401(k) plan. A certain amount is automatically deducted from your paycheck every pay period and deposited in this special account called a 401(k) account. You can invest in a set number of specific mutual funds and sometimes in your company stock too.

The government offers an incentive to people to encourage them to save by making contributions to a 401(k) plan tax deductible. Not only do you not pay income tax on the contributions, but you don’t have to pay payroll tax either (currently at ~15.5%). Of course your employer pays the payroll tax, but it saves you the 7.75% that you normally pay.

If this wasn’t enough of an incentive, George W. Bush has granted certain tax-payers, who make less than a certain amount to also get a tax-credit for contributing to their retirement!!! That means you get an additional tax-break to deduct against your other income.

So you get to save on your taxes by lowering your taxable income, get a tax-credit(if eligible) and get to save for your retirement. But wait, there’s more! The money in the account is allowed tax-deferred until you withdraw it at retirement. Which means you don’t have to worry about paying tax on it every year. And it can grow to a much larger sum when you’re not taking out chunks of it every year it taxes.

If you need to withdraw the money before retirement, baring a few hardship clauses, you will be taxed and penalized on withdrawals. But you can borrow the money and pay yourself interest if you have to!

There’s a new twist on the 401(k) plan called the 401(k) Roth. Its new and not many companies offer it. Basically instead of making contributions tax-free and withdrawals taxable, the government has switch this around, making contributions taxable, but withdrawals tax-free. This is a good idea if you’re in a low tax bracket but think you’ll be making more money in the future and might be in a higher tax bracket in retirement.

Bottom line, investing in a 401(k) plan could possibly be one of your most effective wealth creating strategies apart from owning a home especially if the company you work for offers a 401(k) match.

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