The Benefits of Tax-Deferred Investing
Quite simply, a 401k plan is the best savings vehicle available to Americans today. No other savings vehicle offers the benefits of pre-tax investing with the large annual amount that participants are allowed to contribute. Participants whose companies also offer a matching and/or annual profit-sharing contribution have even more reason to invest every dollar possible into their 401k plan.
Here are the three key benefits of the tax-deferral feature of your 401k plan:
1. The amount you get to invest in your 401k account is much greater than the amount that actually comes out of your paycheck:
Because your contribution is deducted from your pay before federal income tax is calculated, you do not pay current income tax on your contributions and the money does not show up on your W-2 form as income. Likewise, you do not pay current income tax on the investment earnings on your 401k savings. By contributing on a pre-tax basis, participants in a tax-deferred plan may greatly reduce their current tax bill.
Generally, a contribution of $100 monthly to a tax-deferred plan may reduce one’s current federal tax bill by $25 - assuming the participant is in a 25% tax bracket (this illustration does not take into consideration the participant’s filing status, dependents and deductions). In essence, the participant is buying $100 for $75.
Also keep in mind that the tax-deferred savings significantly increase as the amount of the contribution increases.
2. You don’t pay money on your 401k earnings until you retire:
One of the greatest single advantages of participating in a tax-deferred plan is that all dividends, interest, capital gains and growth accumulate on a tax-deferred basis while the money remains in the account. The money you save through your 401k, as well as the investment earnings it generates, will be paid to you during retirement. Only when you begin receiving the money will you have to pay income tax on it. This translates into more dollars working for the participant which, in turn, may lead to larger growth potential.
3. Your 401k plan provides a simple way to practice disciplined, consistent investing:
Through systematic payroll contributions, the employee develops a strong investment discipline. Investing becomes automatic, makes saving for retirement easy and eliminates the temptation to skip a contribution. Participants are less likely to miss the money once the first contribution is deducted.
Another benefit derived from an automatic savings program is the application of the "dollar cost averaging" concept which provides the investor with a hedge against market and share-price fluctuations.
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