401(k) - The Best Investment Around

Excerpted from
401(k) Take Charge of Your Future: A Unique and Comprehensive Guide to Getting the Most Out of Your Retirement Plans
By Eric Schurenberg

Suppose a stockbroker called you and pitched an investment that he claimed would shave thousands off this year's tax bill, earn a guaranteed return of 25% to 100%-instantly-and not generate a penny of future income taxes until you decided to sell. If you were smart, you'd mutter something about calling the securities regulators and hang up.

Chances are, though, you've already been pitched this investment or something very like it-but by your employer, not by your stockbroker. The investment, of course, is your 401(k) plan. Your company may call it something different: the savings plan, capital accumulation plan, retirement program, or the like. Hut under any name it is one of the rarest creatures in the financial world: an investment that sounds too good to be true-and happens to be true anyway.

Strictly speaking, a 401(k) is an employee benefit, in that you can participate in one only if you're an eligible employee of a company that offers the plan. And like any other employed benefit, 401(k)s are subject to a maze of government regulations and specific rules imposed by your employer.

But it's misleading to think of your 401(k) as a perk like medical benefits or disability insurance that you get simply by showing up to work. It is an investment, and you have to manage it like one. After all, participation is completely optional. And the return you get from it depends entirely on how much money you put into it, and when, and how you apportion your money among the investment options you're given. In that respect it's not much different from investing in mutual funds through Merrill Lynch. In fact, you'd be perfectly justified to hand that money to Merrill Lynch instead of your 401 (k) plan if you were convinced the brokerage's merchandise would earn you a higher return. But the fact is, it almost certainly can't.

There's nothing magic about the 401(k)'s investment superiority. In effect, Uncle Sam has fixed the fight-by imposing a drastically lighter tax burden on 401(k)s than on almost any other kind of investment. Your employer may get into the act as well, kicking some of its own money into your account for every dollar that you invest. That makes the 401(k) pretty hard to beat. (It's as if your stockbroker agreed to give you, say, $50 for every $100 you invested with him. That would be an irresistible investment, except that the broker would be out of business in about a week.)

Let's take a closer look at all the things that 401(k)s have to offer.

Your Contributions to the Plan Are Tax-Deferred

You're going to encounter the term tax-deferred throughout this book, so we should get it cleared tip right away. Tax-deferred means that you are allowed to put off paying federal income taxes (and state income taxes everywhere but Pennsylvania) on the money you save in the plan. The same friendly tax treatment also applies to any interest or other return that the plan generates. You eventually have to pay up when you withdraw money from the plan-the plans are tax-deferred, remember, not tax-exempt - but in the meantime, all of your savings can grow undisturbed by the IRS. Think of the 401(k) plan as a kind of temporary tax haven, a sort of Cayman Islands for your money. Everything that goes into the plan escapes the long arm of the U.S. tax collectors, as does everything that goes on within the plan. But once your money comes out, the revenuers will demand their share at last.

The fact that your contributions are tax-deferred means, in effect, that you get a tax write-off for every dollar you put into the plan. The process works by what the accountants call salary reduction - that is, every dollar you save in the plan reduces the taxable income you have to report to the IRS this year. Say, for example, that you earn $30,000 and you decide to contribute 6% of that amount (or $1,800) to your 401(k). When your W-2 arrives at the beginning of next year, it will show that your earnings subject to federal (and most state) taxes were $28,200. In other words, so as far as this year's tax bill is concerned, you never earned the salary that you routed into your 401(k).

Because you don't have to pay taxes on your savings, it takes less self-sacrifice to put money away in a 401 (k) than in almost any other kind of investment. Say, for example, that you are in the 28% federal tax bracket and the 5% state tax bracket. (That means that of each additional dollar you earn, you have to pay 28 cents to Uncle Sam and 5 cents to your state's tax authorities.) If you contribute $1,800 a year to your 401(k), you reduce your federal income taxes by $504 and your state income taxes by $90. In other words, you have contributed $1,800 to your future financial security, but you denied yourself only $1,206 in spendable income today. (The table above will take you through the arithmetic.) Think of it as a 33%-off sale on your retirement savings.

Your Investment Grows Tax-Deferred

An even more impressive way to measure the benefits of tax deferral is to look at how fast your money grows in a 401(k) compared with a fully taxable (but otherwise identical) investment. Suppose, for example, that instead of shunting that $1,800 a year into your 401(k), you decided to receive it as salary and invest it in, say, a certificate of deposit from your bank earning 7%. By the time the $1,800 reaches you, unfortunately, there will be only $1,206 left. That's all that would remain after the federal and state tax men were finished with your paycheck. But, gamely, you hand the money to your bank and wait for it to grow.

Each year the CD generates $84 in interest (7% of $1,206), which you plow back into the CD to make it grow faster. But that $84 is likewise subject to state and federal taxes; so after figuring in taxes, your CD investment leaves you ahead by only $56 ($84 minus 33%) a year.

Your 401(k), by contrast, doesn't get bogged down by taxes. In that plan, your full $1,800 goes to work for you immediately, and its investment earnings get plowed back into your account at full strength. The result: Even if your 401(k) earns the same 7% as the bank CD, it will grow to a much larger sum much sooner. How much larger? Take a look at the chart on page 6. Assuming that you are in the 33% combined federal and state tax bracket and able to save $1,800 a year for 30 years, you would end up with $170,000 in your 401 (k) plan and just $76,000 in the fully taxable CD.

Your Employer May Match Your Contribution

If tax deferral supercharges the return on the investments in your 401(k), the company match switches on double afterburners. In a match, the employer promises to kick in a certain amount-typically between 25% and $1.50-for every dollar you contribute. That means, in effect, that you get an instant return of 25% to 150% on your money-a claim that no other legal investment can make. And talk about boosting your returns: adding a 50% employer match to the plan represented in the chart on page 6, for example, zooms the plan's final payout from $170,000 to more than $255,000.