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401Kafe
401(k) Advantages |
There are many advantages
to saving in a 401(k) plan. Let's look at some of the unique benefits these plans offer.
Pretax Investing
As we mentioned, your 401(k) contribution is deducted before taxes are taken out.
That helps you in two ways.
First, it means you will be taxed on a smaller gross income, so your income tax bill will
be less. Say you have elected to contribute 6% of your salary to your 401(k). The income
tax bill you pay will be based on your salary minus that 6%. So if you were earning
$30,000 per year, were taxed at the 1998 rate of 28%, and contributed 6% to a 401(k), your
annual tax bill would be $500 less than if you were not contributing to a 401(k).
Second, pretax investing also increases your investing power. In the example above, 6% of
your pretax income amounts to $1,800. But 6% of your post-tax income comes to less than
$1,700. If you wanted to match that $1,800 through post-tax investing, you'd have to cut
into your own take-home pay.
Tax-Deferred Growth on Your Investment
Since you don't pay taxes on any return you make on a 401(k) investment until you withdraw
money at retirement, you'll accumulate savings faster. Tax-deferred growth gives you the
full benefit of compounding growth. Every year the full amount of your investment grows
without interruption from the IRS.
If you were 40 years from retirement and begin contributing $2,000 per year to a 401(k),
that money would grow quickly. Say your investment options offered an annual return of
10%, and you contributed faithfully every year. At the end of 40 years, you would have
contributed a total of $80,000. But your 401(k) account would be worth $973,684,
thanks to the power of tax-deferred compounding.
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