Maximize your contributions to your company plan

The name 401k refers to the section of the Internal Revenue Code that allows for this type of retirement vehicle. 401k's are tax-deferred retirement plans sponsored by company employers.

Generally, a certain portion of an employee's pre-tax income is deducted from his or her paycheck and deposited into the plan, producing an immediate tax deduction for the employee, not to mention deferring any future income and capital gains earned until the funds are withdrawn from the plan.

An employer can make up to three kinds of contributions to an employee's 401k: a basic contribution, representing a small percentage of the employee's annual salary; a matching contribution, based on the employee's contribution; and the employer's profit-sharing contribution. The funds within the plan are then invested by the employee in a number of eligible investments including stocks, bonds and mutual funds.

The current maximum annual contribution you can make to your 401k is $15,000 unless you are over the age of 50 and then it jumps to $20,000. Furthermore, for those over 50 whose employers allow catch-up contributions, the maximum for that is an additional $5,000. The benefits from maximizing your contribution are almost endless.

Here's an example that illustrates the benefits:

  • You are 51 years old and earn $75,000 a year.
  • Your employer's basic contribution is two percent of your annual salary.
  • Your contribution is 10 percent of your annual salary up to the maximum of $25,000 that includes the catch-up contribution.
  • For every dollar you contribute, your employer matches that dollar with 25 cents of their own.
  • Finally, you're entitled to 3 percent of your pay in the company profit-sharing plan.

The total contributions in this example are $13,125. Of that, $9,000 would be your own, reducing taxes paid by $3,150 and your net contribution to $5,850. In return you would receive more than double that amount in tax-deferred investments.

This should drive home the point that maximizing your 401k is a critical tool in meeting your retirement goals.

However, there are some disadvantages. These include:

  • Any money you withdraw from the plan before age 59½ is taxed as income and an additional penalty of 10 percent is also added.
  • 401k's are not insurable under the Pension Benefit Guaranty Corporation
  • Employer contributions take a few years to vest.
  • There is a maximum contribution level each year.
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