|Should I contribute to my 401(k) plan at work?
Yes. Unless you absolutely cannot afford to set aside any
dollars whatsoever, you should contribute to your employer's 401(k) plan. A
401(k) plan is one of the most powerful tools you can use to save for your
The first benefit is that your pre-tax contributions to a
401(k) plan are not taxed as current income. They come right off the top of
your salary before taxes are withheld. This reduces your taxable income,
allowing you to pay less in taxes each year. You'll eventually pay taxes on
amounts contributed when you withdraw money from the plan, but you may be in a
lower tax bracket by then. You may even qualify for a partial tax credit for
Furthermore, money held in a 401(k) plan grows tax deferred.
The investment earnings on plan assets are not taxed as long as they remain
inside the plan. Only when you withdraw those earnings will you pay taxes on
them (again, possibly at a lower rate). In the meantime, tax-deferred growth
gives you the opportunity to build a substantial 401(k) balance over the long
term, depending on investment performance.
If you're lucky, your employer will match your contributions
up to a certain level (e.g., 50 cents on the dollar up to 6% of your
salary). You typically become vested in your employer's contributions and
related earnings through years of service (the details depend on the plan).
Employer contributions are also pre-tax and are basically free money (once
you're vested), so you should try to take full advantage of them. If you fail
to make contributions and receive no match, you are actually walking away from
money your employer is offering to you.
Another feature that many 401(k) plans offer is
the ability to borrow up to 50% of your vested balance (or $50,000, if less) at a reasonable interest
rate. You can use a plan loan to pay off high-interest debts or meet other
large expenses, like the purchase of a car. You typically won't be taxed or
penalized on amounts you borrow as long as the loan is repaid within five
years. Repayment may be required within a shorter time frame, however, if you leave your
employer. Loan payments are deducted from your paycheck with after-tax dollars.
Finally, 401(k)s are a very convenient and reliable way to
save. You decide what percentage of your salary to contribute, up to allowable
limits. Your contributions are deducted automatically from your paycheck each pay
period. Because the money never passes through your hands, there's no
temptation to spend it or skip a contribution here and there. Most plans allow
for contributions as small as 1% of your pay.
Note: Your employer may also allow you to make after-tax
"Roth" contributions to your 401(k) plan. Because your Roth contributions are
after tax, they don't reduce your current income like pre-tax contributions.
But because they're after-tax, your Roth contributions are always tax free when
paid out to you. But the main attraction of Roth 401(k) contributions is that
the earnings on your contributions are also tax free if your distribution is
"qualified." In general, a distribution is qualified if it is made more than
five years after the year you make your first Roth 401(k) contribution, and you
are either 59½ or disabled when you receive the payment.