As the holiday season is upon us, the last thing you probably want to think about is your 401K, or any type of matter relating to retirement. Don’t worry, it’s a wonderful subject to talk about because it’s the gift that keeps on giving well into your retirement.
Over the years, I’ve had quite a few questions about what exactly a 401K is and why it’s beneficial to contribute to it.
Understanding Your 401K
A 401K is a retirement plan sponsored by your employer. The contributions made is considered tax deductible because you can save a portion of your paycheck before taxes are taken out, which reduces the amount of taxes you pay.
The earnings from your savings are tax deferred until the money is withdrawn from the account, given you’re at least 59 ½ years old, at which time you will pay ordinary income taxes. However, if you must withdraw the funds before age 59 ½, then there may be a 10% IRS penalty in addition to the ordinary income tax. However, there are some situations where you will not incur a penalty from early distribution but will still be taxed nevertheless. Below are some scenarios where you may not incur the 10% penalty.
- Permanent disability of the participant.
- Qualified 1st time home buyer for owner occupied property (taken out as a loan).
- Qualified military reservists called to active duty.
- Rollover of your 401K to another qualified IRA plan for previous employers. You will not be allowed to rollover your 401K for an employer you currently work for.
Why Save for Retirement?
As the aging population continues to grow older and living longer, we are more likely to spend a longer period in retirement. Below are statistical data.
- 1970: Men spent an average of 11.3 years in retirement
Women spent an average of 15 years in retirement
- 1990: Men spent an average of 15.5 years in retirement
Women spent an average of 19.1 years in retirement
- 2016: Men spent an average of 17.2 years in retirement
Women spent an average of 20.6 years in retirement
In addition to the need to save more as we live longer, we also must account for year-over-year inflation. The most current rate of inflation is 2.5% for the 12 months ended October,2018 as published in November,2018 by the U.S. Labor Department.
Example of the Impact of Pre-Tax Savings
|Regular Savings||401K Savings Plan|
|before tax savings of 10%||$0.00||$5,000.00|
|Federal tax of 22% (assumed)||-$11,000.00||(22% X $50,000)||-$9,900.00||(22% X $45,000)|
|Social Security/Medicare tax @ 7.65%||-$3,825.00||(7.65% X $50,000)||-$3,825.00||(7.65% X $50,000)|
|After tax savings of 10%||-$5,000.00||$0.00|
|Employee’s net take home pay||$30,175.00||$31,275.00||extra $1,100 in take home pay with 401K|
Now let’s say that your employer has a matching program of 3%, then you will have an additional $1,500 in your 401K savings along with an extra $1,100 in take home pay.
Besides thinking about food and shopping this holiday season, bring yourself some joy in the coming year by understanding the importance of adding or increasing your 401K savings to benefit your golden years.
For more savings tips, check out 10 Simple Tips to Eliminate Financial Stress.
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