Making the Most Out of Your 401k

What is a 401k?

A 401k is a retirement account for employees of a business. It is named for the section of the IRS tax code that allows for the provision.

The main feature of a 401k is that contributions are pre-tax, so they are essentially a write-off that will lower the individual's tax burden. In exchange, the account is illiquid: you are not allowed to draw on the account until retirement (as early as age 55) without paying a penalty. Also, withdrawals are taxed as ordinary income, not as capital gains, the way standard brokerage account withdrawals are taxed.

Who Can Invest in a 401k?

Any employee of a company that has set up a 401k can invest a part of their income up to a set limit ($15,000 for 2006).

Why Invest in a 401k?

The 401k provision of the tax code was never intended to be the staple vehicle for retirement savings. It has simply evolved that way.

Though the 401k was initially seen as a supplemental retirement option, companies have seen it as a way to shift the responsibility for putting money aside for retirement to their employees.

Since the inception of the 401k, predefined benefit plans, in which companies set aside a certain amount in order to pay retired employees for their years of service, have all but disappeared.

As a result, it is more important than ever for employees to take advantage of the benefits of such a plan.

In exchange, many employers offer incentives, such as matching contributions, where the company matches your investment dollar-for-dollar up to a set percentage. If your employer offers such an incentive it is important to take full advantage of it by investing up to the limit.

Most of us don't have a predefined plan to fall back on, so the ball is in our court, and a 401k is the best play we have.

What About IRAs?

IRAs are great, in many ways better than a 401k, and they should be a part of every retirement plan. There is often more flexibility in terms of where you can put your money with IRAs, and you can even choose to use the Roth IRA, which is taxed in today's dollars in exchange for tax-free withdrawals upon retirement.

The problem is that almost no one can retire solely on IRA accounts.

The investment maximum ($4,000 for 2006 and 2007 if you're under 50; $5,000 if you're over 50) limits their effectiveness as a retirement tool. 401k plans, with a $15,000 limit, are a much more effective tax-deferred tool.

So, we need multiple tools to prepare for retirement, and the 401k is the most important tool we have.

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