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401(k) Basics Answers
What is a 401(k)?
The term 401(k) comes from a section of the Internal
Revenue Service tax code: Section 401(k). It is a type of personal pension
plan offered by your employer. You decide how much of your paycheck you
want automatically deducted and contributed to the plan - all before federal,
state and local income taxes are taken out! You then choose how to invest
your contributions, depending on the choices in your 401(k) plan. When
you retire, you end up with all the money you originally put in, plus
the earnings on your investments, minus income taxes. Go to our 401(k)
Wealth Calculator TM to see how your money could grow in a 401(k).
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What's the benefit of a 401(k)
over other retirement investments?
Lots. Here's a list of powerful reasons to invest in
your 401(k) plan:
- Pre-tax contributions. The money you
put in a 401(k) account is not subject to current federal, state or
local income taxes. Your contribution reduces your income, dollar for
dollar. The result is you pay less taxes each and every paycheck.
- Tax-deferred growth.
When you make money off your investments you pay taxes on the increase.
But if you're investments are inside a 401(k), you won't pay taxes on
the earnings until they are withdrawn, which hopefully won't be until
retirement. Overtime, the compounding effect of this tax deferred growth
can have an extrodinary impact on your savings.
- Company matching.
The company match is the easiest way to make an instant return on your
money. Many employers offer to match a percentage or set dollar amount
of the money that you put into your 401(k). In a plan where your employer
is matching your contribution at 50 cents on the dollar, you've made
a fast 50% return. Matching contributions should be thought of as free
money. Don't leave any on the table. If your company does not presently
make a matching contribution, don't let that get the in the way of your
savings. The favorable tax treatment that your money will receive should
be incentive enough.
- Instant savings.
This is arguably the easiest way to force yourself to save for retirement.
Before you even get the chance to blow your paycheck, your 401(k) contributions
have been taken out and deposited.
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Can
I open an IRA or a Roth IRA if I already have a 401k?
Yes, depending on your income. Having a 401(k)
and your level of income determines whether you can contribute to and/or
deduct contributions to a traditional IRA. You could also opt for a Roth
IRA along with a 401(k), though contributions are not tax-deductible.
For 2007 you can contribute up to $15,500 of pre-taxed money to a 401(k),
but only $4,000 to the traditional IRA or Roth IRA.
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