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Personal Finance

Introduction | Investment Basics | 401(k) Defined | 401(k) Advantages | 401(k) Drawbacks

401(k) Advantages

There are many advantages to saving in a 401(k) plan. Let's look at some of the unique benefits these plans offer.

Pretax Investing

As we mentioned, your 401(k) contribution is deducted before taxes are taken out. That helps you in two ways.

First, it means you will be taxed on a smaller gross income, so your income tax bill will be less. Say you have elected to contribute 6% of your salary to your 401(k). The income tax bill you pay will be based on your salary minus that 6%. So if you were earning $30,000 per year, were taxed at the 1998 rate of 28%, and contributed 6% to a 401(k), your annual tax bill would be $500 less than if you were not contributing to a 401(k).

Second, pretax investing also increases your investing power. In the example above, 6% of your pretax income amounts to $1,800. But 6% of your post-tax income comes to less than $1,700. If you wanted to match that $1,800 through post-tax investing, you'd have to cut into your own take-home pay.

Tax-Deferred Growth on Your Investment

Since you don't pay taxes on any return you make on a 401(k) investment until you withdraw money at retirement, you'll accumulate savings faster. Tax-deferred growth gives you the full benefit of compounding growth. Every year the full amount of your investment grows without interruption from the IRS.

If you were 40 years from retirement and begin contributing $2,000 per year to a 401(k), that money would grow quickly. Say your investment options offered an annual return of 10%, and you contributed faithfully every year. At the end of 40 years, you would have contributed a total of $80,000. But your 401(k) account would be worth $973,684, thanks to the power of tax-deferred compounding.

Access to the Stock and Bond Markets

Stock and bond mutual funds are frequently among the investment options offered by 401(k) plans. A mutual fund is money pooled from many investors. Experts called fund managers invest that money in stocks, bonds and other assets with a view to achieving a certain amount of return (the fund's "objective").

Mutual funds allow investors who may not otherwise have sufficient assets or expertise to "play" directly in the stock and bond markets -- and to reap the potential benefits of those markets.

Professional Management

When you participate in a 401(k) plan, professionals work for you. Your plan administrator (the company in charge of administering your plan) provides you with periodic account statements that let you know how your investments have performed. If you want to change your contribution amount or how your money is invested, you simply notify your plan administrator.

What's more, if you invest in mutual funds through your 401(k), you also benefit from the expertise of the fund's management team. It's up to the fund managers to decide when to buy or sell securities and to keep the fund on track toward meeting its objective.

Ease and Convenience

401(k) providers work hard to make your investment experience a pleasant one. Potential investors sometimes worry that they won't be able to keep track of their 401(k) contributions and won't know how their money is invested. Nothing could be further from the truth. Once you make your contribution and investment decisions, your 401(k) account is meticulously managed and you are kept up to date through periodic reports.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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