Retirement Accounts - 401k's

I have been looking into getting free money, but then there is nothing that is free or maybe there is :) If your employer matches any amount of money that you put into your retirement account, then you maybe losing out on free money given away by your employer and some tax savings.

Example - Free Money
John Smith's employer matches 50% of the money John contributes to his 401K retirement account, upto 6% of John's salary. Also, this money comes out of John's salary pretax, so this reduces this current taxable income. Lets say John earns $2500 per month, he contributes 6% ($150) to his 401K savings account, his company matches 50%($75), so if John contributes $150 per month to his retirement account, his company puts in $75 (that is 50% instant profit). He does not earn any contribution from the company if he contributes nothing for his retirement. Some institutions give upto 200% of your contribution, $300 in John's case, for a total of $150.

Investments
This 401K money is put in various investments, depending on what you company provides, from a low yeilding money market account (better than most banks savings accounts) to mutual funds to stocks to self managed 401K's. There are ways in which you can get your favorite brokrage to maintain your 401K investments.

Tax Savings
John's initial taxable income was $2500 per month, @ 25% tax rate that is $625 in tax, now after his 6% contribution, his taxable income reduces to $2500 - $150 = $2350 and his tax reduces to $587.5, that is an additional $37.5 savings in taxes.

Taxes
If withdrawls from the 401K account are made after 59 1/2 years, then these withdrawals are taxed at the rate in which John falls in, at that age, this is expected to be less than his current rate of 25% because he might just be withdrawing $1500 from his 401k at that age.

Growing Money
It is said that money attracts money and the interest earned on compounding are great, if we take the average stock market return of 9% per year, $1000 invested by John at age 25 becomes $2367 at age 35, $5604 at age 45, $20413 at age 60. This is just the initial $1000, of course as John keeps adding more money per month in his retirement account, his final retirement nest egg is much bigger.

Cons

• If John withdraws money before age 59 1/2 from his 401k he is subjected to penalty and taxes.
• He has to pay taxes on the money in his retirement.

Personal Comments

• I think it is good to maximize your 401 benefits, upto what your employer matches, so if your employer matches upto only 4% of your salary, keep your 401k contributions to 4%. Because the principal (your money and the matched money) and any income will be taxed in the future.
• Roth IRA's: If the employer matches nothing, it is best to invest in Roth IRA's (more about this in the next post). Also, it is best to put your money in Roth IRA if you want to contribute more to your retirement account then what your employer matches. For eg. if John wants to put 10% of this salary in retirement accounts, he should contribute the first 6% in 401K and the next 4% in Roth IRA's

Links

Retirement Calulator - http://www.bloomberg.com/analysis/calculators/401k.html

More about Roth IRA's in the next post.