The traditional 401k plan -- where you invest pre-tax dollars -- provides a way to save for retirement while enjoying tax benefits not available through personal savings or investment. Many plans match portions of participants' contributions and provide a choice of investment options, allowing participants to customize their accounts to meet their own needs.
Contributing pre-tax dollars in a 401k means your money is invested in the plan before any taxes are withheld by your employer. This reduces the taxable income reported to the IRS. For example, if your gross income for the year is $40,000, and you contribute $8,000 to your 401k, you are taxed as though your income was only $32,000. Employers typically deduct the contribution percentage you select from each paycheck, simplifying the deduction and tax preparation process for you.
In addition to lowering your taxable income, a 401k plan offers other tax benefits. Investment earnings grow on a tax-deferred basis, meaning you do not pay taxes on earnings within the plan. This, along with pre-tax contributions, allows your account to grow much faster than if taxes were being paid all along.
Many employers match the 401k contributions made by their employees, with a common rate being 50 cents on the dollar for the first six percent of your compensation you contribute, according to the CNNMoney website. Your employer can match your contribution dollar for dollar if it chooses, although the most it can contribute is six percent of your pre-tax compensation. Over time, you'll become fully vested, meaning you'll "own" the entire amount of the employer's matching contributions, even if you leave the company. While this does not reduce your taxable income, per se, an employer match is like receiving an additional percentage of your income tax-deferred.
Employee contributions as well as employer matches and investment earnings are not tax-free. Eventually, when you begin taking distributions, they will be taxed as ordinary income. In addition, early distributions -- usually before you reach age 59 1/2 -- will be subject to an additional 10 percent penalty tax. In many cases, however, retired plan participants are in a lower income tax bracket than they were during employment. This means an overall tax savings in the long run.
- Creatas/Creatas/Getty Images