As an investor, you have many different accounts that you can use to invest your money in. And each of these different accounts has its own advantages and disadvantages. But there is one account that stands head and shoulders above the rest. It is your 401(k) plan.
What makes your 401(k) plan the best place to invest your money for the long term? In this post I will show you all of the reasons why this type of investment account has the greatest impact on the growth of your money.
What Is A 401(k) Plan?
Of course, we first need to make sure that we are all on the same page as to what a 401(k) plan is. It is a defined contribution plan that allows workers to save for their retirement. In order to invest in a 401(k) plan, you need to work for a company that offers this investment vehicle or you have to be self-employed and open one yourself.
A 401(k) plan typically works by having you instruct your employer to withhold a percent of your pay from your paycheck and invest it into your plan. In many cases, your employer will also match a portion of your contribution as well.
A typical match might be 50% on the first 3% you contribute. So if you save $100 per paycheck in your 401(k) plan, your employer will match this and put in $50.
The Many Benefits Of A 401(k) Plan
Now we get to the good stuff. Why exactly does a 401(k) plan outshine all other types of investment accounts? Here is the list of reasons why.
#1. Shield Money From Taxes. When you contribute to your 401(k) plan, the money you invest is taken out pre-tax. This means when you do get taxed, you are taxed on less income than you otherwise would be.
For example, if you make $50,000 and are in the 25% tax bracket, you are paying $12,500 a year in federal taxes. But if you contribute $18,000 to your 401(k) plan, you taxable income is now $32,000 and you are in the 20% tax bracket. You end up paying $6,400 in federal taxes, saving yourself close to $6,000 in taxes.
#2. Free Money. In most cases, employers will match a portion of your contributions you make to your retirement plan. This is in essence free money for you. If you don’t save in your plan, then you don’t get the money. Therefore it is critical that you save at least enough to get a full match.
How big of an impact is this? Let’s say you invest $1,500 annually into your plan, which is 3% of your salary. You do not get an employer match. In 30 years with an 8% growth rate, you end up with just over $183,000.
Keeping everything the same but adding in a 50% employer match on the 3% you contribute and in 30 years you end up with just over $276,000. That is an additional $93,000 thanks to the employer match.
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#3. Tax Deferred Events. When you get paid a dividend or capital gain in a taxable account, that income is taxed and you have to pay it that year. With a 401(k) plan, any income you earn in the account is tax deferred until you begin to withdraw the money.
This allows any dividends and capital gains to grow tax free for many years. Additionally, you can freely buy and sell investments in your 401(k) plan without any tax consequence either.
#4. Automatic Savings. The best way to build long term wealth is to make saving money automatic. When you can put it on auto-pilot and not have to think about it, you end up with more money in the long run.
Why is this? Because you don’t have to remember to do it. Let’s face it, life gets busy and we forget and put things off all the time. The more we can automate, the better off we will be.
TIP: Consider a service like Blooom to manage your 401k easily and automatically.
And investing is no exception. When you automate your investing, you always invest and thus are always growing your wealth. By investing in a 401(k) plan, you have your employer take money from your paycheck automatically and invest it for you. No more thinking or remembering, it just happens and as a result, your wealth grows.
As you can see, your 401(k) plan is an excellent vehicle for building long term wealth. Given the various benefits, there is zero reason why you shouldn’t be putting as much money into this plan as possible. Doing so only improves your long term finances for the better.
So stop making investing confusing by trying to pick the perfect account and best investments. You now know that a 401(k) plan is a great account to put your money into, so don’t delay and get started saving by investing in this account today.
4 thoughts on “Why Your 401(k) Plan Is Your Most Powerful Investment Account”
Great article and very true. While I’ve always contributed to my 401k to get the free employer matching, I wish I had focused on putting more in to get that extra tax benefit and tax free growth the last couple years.
Goal is to max it out this year!
I maxed my 401K out every year except when plan problems wouldn’t allow it and built it up to a seven figure balance when I early retired and moved it to an IRA. It was completely painless and now represents a helpful part of my FI status
I’d say if you are given the opportunity to invest in your 401k plan, please do so, or better yet maximize your contribution. Several years ago when I used to work for the Federal government, a few of my co-workers were not contributing to their TSP (401k). They claimed that they cannot afford to contribute even the minimum contribution they were allowed to. Last year, I happen to bump into one of them and he told me that he finally started contributing and that he regretted that he did not make any contributions for almost 10 years.
Agreed, that 401k is a great thing. During my working career, I maxed out every year. And when I moved on from each job, I rolled over the 401k funds into IRAs. Plus fully funded all post-tax Roth IRAs every year. Now I have a boatload of IRA money. All good, yes?
Well, in addition to the tax deferred money from 401l/IRAs, one also needs cash. Dont neglect that need either. I wanted to buy a house, and needed a down payment. Which I found hard to do, because I had put most of assets into tax-deferred accounts, it was hard. Finally did make if happen, but it took a stretch.
So while I think 401ks are great, in retrospect I should have foregone some Roth IRAs to build up a better cash position.