A 401(k) is an employer-sponsored retirement savings account allowing participants to save pre-tax money. The plan lets employees choose what percentage of their paycheck to contribute and invest in various choices. Investing in a 401(k) can have big returns thanks to compounding. It may not sound like much, but it can significantly affect retirement savings.

Matching Contributions

Employer matching contributions are an excellent way to help employees save more for retirement. According to research from the Plan Sponsor Council of America, the most common matching formula is 50 cents for each dollar contributed by the employee, up to a maximum of 6% of pay.

Some companies match every paycheck, while others do it per payroll. The latter option helps employees save more by immediately getting their employer-matched funds into their accounts. Many companies also provide a profit-sharing contribution at the end of each year to give employees an extra incentive to keep their retirement contributions in place, even during tough market times.

Offering a company 401k match program is an important part of any business’s benefits package, and it is an effective way to recruit and retain talent. 62% of workers cite the availability of their employer’s 401k plan matches as one of the top reasons they chose to work for their current employers.

In addition, the best solo 401k suppliers emphasize employee contributions and investment gains are not taxed when they go into their accounts, only when they withdraw them in retirement. This is a benefit that most people don’t realize, which makes it essential to educate employees and encourage them to make the most of the 401k option by saving enough to qualify for their employer’s matching contributions.

Tax-Deferred Savings

401(k) plans allow employees to contribute pre-tax, lowering their take-home pay and taxes paid. While this doesn’t necessarily save them money in the short term, it does allow them to invest more of their paychecks and lessen their tax burden in the long run.

In addition, contributions grow tax-deferred, meaning they’ll only be taxed upon withdrawal. This gives them a chance to compound when investment earnings produce their earnings, allowing them to grow even more over time. This can mean substantial savings since many retirees are in a lower income tax bracket than during their working years. Although tax-advantaged accounts have a few drawbacks, such as penalties for early withdrawal and restrictions on how funds can be used, they provide a powerful incentive to save more and put that money into the right investments. Conventional wisdom states that it’s necessary to replace between 65% and 90% of your current income during retirement, and the benefits of tax-deferred savings can make all the difference in reaching that goal.

Compound Interest

Compound interest is a powerful force that can make wealth grow faster than simple interest. It’s the result of earning returns on your original investment and the accumulated returns of previous years. Those additional returns generate their interest, further compounding and growing your investment.

While it might not seem like much when looking at your 401(k) balance, the power of compounding is significant and can help you reach your retirement and financial goals more quickly. By starting early, saving consistently, and choosing investments that have the potential to earn high returns, you can significantly accelerate your growth.

Another reason to save in your 401(k) is that the money you contribute and any employer matching contributions are tax-free. Withdrawals from your account are subject to income taxes, but you only pay them once you need the money in retirement.

For people who don’t have the benefit of a 401(k), you can still take advantage of compounding by investing in taxable accounts, such as an individual retirement account (IRA) or a 529 plan for education savings. However, talk with a financial professional about your options and investment strategies before making any decisions. 

Borrowing Against Your Account

You might want to borrow against your 401(k) for a few reasons, but it’s important to understand the risks involved. While we usually recommend against it, borrowing can be an option for those who need cash quickly. It’s generally faster and easier than applying for a bank loan, and most 401(k) plans don’t require any credit checks or an application process. Often, repayment is automatic, with monthly payments (plus interest) deducted directly from your paycheck. The biggest disadvantage of a 401(k) loan is that the money you take out will no longer be invested in the market, meaning it will miss out on future growth. This is especially problematic in a down market, where the impact can be much greater. It’s also worth mentioning that, during the payback period, you cannot contribute to your 401(k) account.

Lastly, most 401(k) plans require you to repay your loan within five years or less unless you use the funds to purchase your primary residence. In addition, leaving your job with an outstanding 401(k) loan can result in additional taxes and penalties. If you are considering a 401(k) loan, we suggest consulting a qualified financial professional to discuss your options. 

Jane