Monday, December 18, 2006

What is 401(k) plan: Do you need it or not ?

What exactly is 401(k) plan?. I have been reading a lot to understand it and here are some thought that i would like to share with you and give you the opportunity as to whether 401(k) plan is suitable or not for you

Is it possible for us to get free money. Yes there is an option in investing into the 401k plan.401k plan is same as the provident fund that i have been familiar for all my life. Most of the employees offer the 401k plan and if not you can choose one of your own.

A 401k plan could be called as an employment sponsored retirement plan. In a 401k plan an employee saves money for his retirement while deferring taxes on the saved money until withdrawal or retirement from job.

Consider an example: John makes about 60000$ per year and his age is 24yrs. Assuming Johns employee contributes 50% of the money that he contributes to his 401k plan with a max of 6% of johns salary. So here John earns 5000$ per month and contributes 300$ towards the 401k plan. His company matches 50% of it and so that would be 150$. John will not earn anything if he doesnt contribute anything to the 401k plan

The other advantage is that earnings from investments in 401k plan(interest,dividends) are not taxable. The money in 401k plan can be invested right from a saving bank account,money market account,mutual fund and to stocks.

How do you save tax by investing in 401k plan: In johns case he earns 60000$ per year and he contributes 3600$ per year towards 401k plan. so the net taxable income would be 56,400$. Assuming a tax rate of 30% john would end up paying 1500$ per month as tax. On contibution to 401k plan he would pay only 1410$. He would be saving 90$ per month and about 1080$ per year.

Taxes: If withdrawals are made before 59 1/2 yrs then the withdrawals are charges at the current rate but after that the tax rate is going to be less as he might just be withdrawing about 2000$ per month at the age of 60. Most companies prevent withdrawals from the 401k account.

Currently there is a limit to which the employee can contribute to 401k plan. A max of 15,500$ has been set for the year 2007. So assuming john gets a rise of 5% every year in his job and he continues to contribute 3600$ per year towards his 401k plan. Then at the age of 60yrs john would have $917,610 from just his 401k plan. This include an annual rate of return at 5%

From the calculations i think one should maximize the 401k plan and contibute a good amount to earn high returns at retirement.

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