If you’re lucky enough to be introduced to a 401(k), you’ll make a friend for life.
Even if you’re just starting your first real job—actually, especially if you’re just starting your first real job—it’s time to start thinking about retiring. That’s not a comment on how motivated—or unmotivated—you are, or a suggestion that you should wish your life away.
It’s just reality.
That’s because of you, like many people, will be responsible for supporting yourself during the 30 or 40 years you can expect to live after you retire. To do that, you need a source of income that will stretch further than the safety net of Social Security and be more reliable than winning the lottery.
Some—but increasingly few employers offer traditional pensions, which pay you retirement income based on your final salary and time on the job. Others contribute to a cash balance, profit sharing, or another plan on your behalf. But most employers offer you, instead, the opportunity to participate in a salary reduction plan, such as a 401(k) or 403(b).
ON THE BANDWAGON
If your employer offers a salary reduction plan, it’s usually the most painless way to set aside money for the future. All you have to do is agree to have a percentage of your gross income withheld each pay period. Participating in a salary reduction plan has three big advantages:
Any tax-deferred contributions reduce your current income taxes since they’re subtracted from your income before tax withholding is calculated.
Contributions to a tax-free Roth 401(k) or 403(b) aren’t deductible. But when you withdraw after 59., your earnings are tax-free if your account has been open at least five years.
Many employers match a percentage of the contributions you make—as close to a free lunch as you’re likely to get since you don’t owe income tax now on that amount either.
Any earnings in your retirement plan account accumulate tax-deferred. That means the earnings are reinvested to increase the base on which additional earnings can accumulate, a process called compounding.
When compounding is involved, time is money. The more years that you add contributions to your plan, and the more years that any earnings increase your principal, the larger your account balance has the potential to grow.
Of course, there are no guarantees about either the rate or the regularity of the earnings. They may be outstanding one year and dismal the next, or they may go through longer, but still alternating, periods of growth and decline. That’s the reality of investing.
Having time on your side means that bumps in the road, like a period when investment prices go down and your account value shrinks, may be setbacks. But they don’t have to be fatal.
A 401(k) BY ANY OTHER NAME…
401(k) plans are the most common, and best known, employer-sponsored salary reduction plans. But they’re not the only ones. If you work for a not-for-profit organization such as a school or college, a hospital, a cultural institution, or a charitable organization, your employer may offer a 403(b) plan, which operates in much the same way as a 401(k).
Similarly, the plan a state or municipal government offers may be a 457 plan, while federal government departments and agencies provide a thrift savings plan (TSP). And if you work for a small company—one with fewer than 100 employees—you may be part of a SIMPLE plan, an acronym for Savings Incentive Match Plan for Employees.
The rules differ slightly for each type of plan, and even among plans of the same type. But all offer the opportunity for tax-deferred earnings.