A 401(k) plan represents one of the most powerful retirement savings opportunities available today. If your employer offers a 401(k) plan and you’re not participating in it, you should be.
Contribute as much as possible
The more you can save for retirement, the better your chances of enjoying a comfortable retirement. If you can, max out your contribution up to the legal limit ($17,500 in 2013, $23,000 if you’re age 50 or older). If you need to free up money to do that, try to cut certain expenses. (Note: some plans limit the amount you can contribute.)
Why invest your retirement dollars in a 401(k) plan instead of somewhere else? One reason is that your pretax contributions lower your taxable income for the year. This means you save money in taxes immediately when you contribute to the plan–a big advantage if you’re in a high tax bracket. For example, if you earn $100,000 a year and contribute $17,500 to a 401(k) plan, you’ll only pay federal income taxes on $82,500 instead of $100,000.
Another reason is the power of tax-deferred growth. Any investment earnings compound year after year and aren’t taxable as long as they remain in the plan. Over the long term, this gives you the opportunity to build an substantial sum in your employer’s plan. (Your pretax contributions and any earnings will be taxed when paid to you from the plan.)
Consider Roth contributions
Your 401(k) plan may also allow you to make after-tax Roth contributions. Unlike pre-tax contributions, Roth contributions don’t lower your current taxable income so there’s no immediate tax savings. But because you’ve already paid taxes on those contributions, they’re free from federal income taxes when paid from the plan. And if your distribution is “qualified” (that is, the distribution is made after you satisfy a five-year holding period, and after you reach age 59½, become disabled, or die) any earnings are also tax free.
If your distribution isn’t qualified, any earnings you receive are subject to income tax. A 10% early distribution penalty may also be imposed if you haven’t reached age 59½ (unless an exception applies).
Capture the full employer match
Many employers will match all or part of your contributions. If you can’t max out your 401(k) contributions, you should at least try to contribute as much as necessary to get the full employer match. Employer matching contributions are basically free money. By capturing the full benefit of your employer’s match, you’ll be surprised how much faster your balance grows. If you don’t take advantage of your employer’s generosity, you could be passing up a significant contribution towards your retirement.
Access funds if you must
Another beneficial feature that many 401(k) plans offer is the ability to borrow against your vested balance 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. Immediate repayment may be required, however, if you leave your employer–if you can’t repay the loan, you may be treated as having taken a taxable distribution from the plan.
And remember that when you take a loan from your 401(k) plan, the funds you borrow are generally removed from your plan account until you repay the loan, so you may miss out on the opportunity for additional tax-deferred investment earnings. So loans (and withdrawals if available) should be a last resort.
Evaluate your investment choices
Choose your investments carefully. The right investment mix could be one of your keys to a comfortable retirement. That’s because over the long term, varying rates of return can make a big difference in the size of your 401(k) plan account.