Should an employee contribute to their 401(k) plan at work?
Yes. Unless an employee absolutely cannot afford to set aside any dollars whatsoever, they should contribute to their employer's 401(k) plan. A 401(k) plan is one of the most powerful tools one can use to save for retirement.
The first benefit is that pre-tax contributions to a 401(k) plan are not taxed as current income. They come right off the top of salary before taxes are withheld. This reduces taxable income, allowing one to pay less in taxes each year. They'll eventually pay taxes on amounts contributed when money is withdrawn from the plan, but they may be in a lower tax bracket by then. They may even qualify for a partial tax credit for amounts contributed.
Furthermore, money held in a 401(k) plan grows tax deferred. The investment earnings on plan assets are not taxed as long as they remain inside the plan. Only when those earnings are withdrawn will taxes be paid on them (again, possibly at a lower rate). In the meantime, tax-deferred growth offers the opportunity to build a substantial 401(k) balance over the long term, depending on investment performance.
If an employee is lucky, their employer will match contributions up to a certain level (e.g., 50 cents on the dollar up to 6 percent of your salary). Typically one becomes vested in their employer's contributions and related earnings through years of service (the details depend on the plan). Employer contributions are also pretax, so an employee should try to take full advantage of them. If an employee fails to make contributions and receives no match, they're actually walking away from money their employer is offering them.
Another beneficial feature that many 401(k) plans offer is the ability to borrow against the vested balance at a reasonable interest rate. An employee can use a plan loan to pay off high-interest debts or meet other large expenses, like the purchase of a car. An employee typically won't be taxed or penalized on amounts borrowed as long as the loan is repaid within five years. Immediate repayment may be required, however, if an employee leaves their employer. Loan payments are deducted from their paycheck with after-tax dollars.
Finally, 401(k)s are a very convenient and reliable way to save. An employee decides what percentage of their salary to contribute, up to allowable limits. Contributions are deducted automatically from salary each pay period. Because the money never passes through the employee's hands, there's no temptation to spend it or skip a contribution here and there. Most plans allow for contributions as small as 1 percent of their paycheck.
Note: An employer may also allow an employee to make after-tax "Roth" contributions to a 401(k) plan. Because Roth contributions are after tax they don't reduce current income, like pre-tax contributions. But because they're after-tax, Roth contributions are always tax free when paid out. But the main attraction of Roth 401(k) contributions is that the earnings on contributions are also tax free if a distribution is "qualified." In general, a distribution is qualified if it is made more than five years after the year an employee makes their first Roth 401(k) contribution, and are either 59½ or disabled when they receive the payment.
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