Money 101: Why You Need A 401(k) Now

Retirement seems so far away. Then again, so did 30 and that’s all up in my grill. Like other distant things, thinking about retirement is easy to delay in favor of the triage of daily life. But objects in the mirror are closer than they appear. Since there’s no way to rapidly save for retirement besides a windfall (hello, lottery!), it’s critical to begin saving ASAP. Le sigh. This article will guide you through the basics of the time value of money and its progeny, the 401(k).

T(ime) V(alue) of M(oney) Magic: The magic of compound interest and tax-deferred savings only works over the long term. This is because of the “time value of money” (TVM). TVM is a ubiquitous concept that underlies all of finance. It’s basically financial gravity. If you ever find yourself in a financial discussion that’s gotten away from you, try throwing TVM out there paired with a thoughtful nod; it’s always relevant. TVM means that money today is worth more than money in the future. This is because money today can be invested immediately, and every second it spends invested is a second it spends growing larger (assuming no more financial crises).

You Need Mature Assets: Now think about your savings account. The savings account is an asset and the amount in there is its present value (PV). Picture the PV as an infant that you must feed (add funds to) and care for (adjust the investments periodically, aka re-balancing the portfolio). Eventually, children grow up enough to take care of themselves. Similarly, invested assets generate returns that create a snowball effect called “compounding” — your returns start earning returns. This is the asset “taking care of itself.” Now picture your asset as an adult; it’s future value (FV). Adult assets have their own earning power.

A 401(k) Helps You Grow Your Assets In Three Ways: Infant assets are pretty useless; one hospital bill can wipe out meager retirement savings. You need adult assets to provide for your retirement. But if you don’t start caring for your asset early enough, it may not be mature when you need it. A 401(k) is a savings account that makes it easy to grow your assets to maturity. When you sign up for a 401(k), your salary is reduced (pretax) by some amount, and that money is automatically deposited into the 401(k) savings account. This lowers your taxable income and income tax. Under 2010 tax laws, you can contribute $16,500 to this account annually. Your employer can opt to match these deposits. Together, you and your employer can contribute the lesser of ~$50k or 25 percent of your salary. (The percent of your salary that goes to your 401(k) and the amount the employer matches are both valid bargaining chips in salary negotiations. Push for the max on both.)

Once the money is in the 401(k) account, it gets invested. You must choose how the investments are weighted (risky or safe?), so it’s necessary to learn basic investing rules.

In short, 401(k)s let you win in three ways. First, for every dollar an employee puts into a 401(k), they can get a “free” dollar from their company through matching funds. Second, the employee doesn’t pay (immediate) taxes on the dollar they contributed. If you are taxed at 30 percent, you get to keep the .30 that otherwise would have been paid to taxes. That’s like a .30 gain for you. Third, the employee gets to profit from investing their dollar (including the tax they saved) and the employer’s dollar. Thank you, Congress!

What’s The Catch? 401(k)s are taxed at a normal rate when they pay out. The idea here is that by the time you are retired, you will be subject to a lower effective tax rate than when you were in your prime earning years. Plus, the government wants some of the money back it loaned you in tax deferral. 401(k) funds have a second downside; they are not liquid. 401(k) capital is basically locked up until you’re 60. If funds are withdrawn early, you have to pay 45 percent of it to taxes — ay carumba! This is your normal tax rate (~35 percent for a professional) plus a 10 percent penalty for early withdrawal.

Go Big Or Go Home. Still, 401(k) contributions are a must. Seek employment with firms that offer 401(k) benefits, then annually contribute as much as possible under your company’s policy. Taking salary and funds now that you could have invested for retirement is like a teenager dying: it’s not their time yet … they showed such promise … just think of what they could have become! Seriously, social security is politically unstable and women need more retirement savings due to living longer but making less than men. Protect yourself by going big on your 401(k) immediately.

Photo: iStockphoto

The Money section and all articles within it are sponsored by Free Credit Score; however, the articles are all independently produced by The Frisky and the opinions and views expressed by the writers and experts are their own.

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