Why your 401(k) plan is your most powerful investment account
As an investor, you have many different accounts in which you can invest your money. And each of these different accounts has its own pros and cons. But there is one account that stands out above the rest. It’s your 401(k) plan.
What makes your 401(k) plan the best place to invest your money for the long term? In this article, I’ll show you all the reasons why this type of investment account has the biggest impact on your money growth.
What is a 401(k) plan?
Of course, we first need to make sure we’re all on the same page about what a 401(k) plan is. It is a defined contribution plan that allows workers to save for their retirement. To invest in a 401(k) plan, you must work for a company that offers this investment vehicle or you must be self-employed and open one yourself.
A 401(k) plan typically works by having your employer withhold a percentage of your salary from your paycheck and invest it in your plan. In many cases, your employer will also match part of your contribution.
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 that and contribute $50.
The Many Benefits of a 401(k) Plan
Now on to the good stuff. Why exactly does a 401(k) plan outperform all other types of investment accounts? Here is the list of reasons.
#1. Protect tax money. When you contribute to your 401(k) plan, the money you invest is withdrawn before taxes. This means that when you are taxed, you are taxed on less income than you otherwise would be.
For example, if you earn $50,000 and are in the 25% tax bracket, you pay $12,500 a year in federal taxes. But if you contribute $18,000 to your 401(k) plan, your taxable income is now $32,000 and you’re in the 20% tax bracket. You end up paying $6,400 in federal taxes, saving you almost $6,000 in taxes.
#2. Free money. In most cases, employers will match a portion of your contributions to your pension plan. It’s basically free money for you. If you don’t save in your plan, you don’t get the money. Therefore, it is essential that you save at least enough to get a full match.
What is the magnitude of the impact? Let’s say you invest $1,500 a year in your plan, which is 3% of your salary. You don’t 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 a 50% employer match on the 3% you contribute and in 30 years you end up with just over $276,000. That’s $93,000 more thanks to the employer match.
#3. Tax-deferred events. When you receive a dividend or capital gain in a taxable account, that income is taxed and you must pay it that year. With a 401(k) plan, any income you earn in the account is tax-deferred until you start withdrawing the money.
This allows dividends and capital gains to grow tax-free for many years. Plus, you can freely buy and sell investments in your 401(k) plan without any tax consequences either.
#4. Automatic savings. The best way to build long-term wealth is to make saving automatic. When you can put it on autopilot and not have to think about it, you end up with more money in the long run.
Why is it? Because you don’t have to remember to. Let’s face it, life is busy and we forget and procrastinate. The more we can automate, the better off we will be.
TIP: Consider a service like Bloom to manage your 401k easily and automatically.
And investing is no exception. When you automate your investments, you are always investing and thus increasing your wealth permanently. By investing in a 401(k) plan, your employer automatically takes money from your salary and invests it for you. No more thinking or remembering, it just happens and as a result your wealth increases.
As you can see, your 401(k) plan is a great way to build long-term wealth. Considering the various benefits, there is no reason why you shouldn’t invest as much money as possible in this plan. It only improves your long-term finances for the better.
So stop making investing confusing by trying to choose the perfect account and the best investments. You now know that a 401(k) plan is a great account to put your money in, so don’t delay and start saving by investing in it today.