Nov 6, 2009


A 401k is very similar to an IRA. Read my post on IRA to understand how an IRA works. In a 401K plan, a part of your pretax income (reducing your current tax liability) is deposited into a 401k account. This account can be designated to invest money in stocks, mutual funds, bonds. When you retire, you pay taxes on whatever amount you take out of this pool of money (principal + earnings). There is also something known as ROTH 401K which is similar to ROTH IRA where you put after tax money and let the earnings grow and never pay any taxes when you retrieve the money at retirement.

For year 2009, IRS has a limit on employee contribution of $16,500. So that's the maximum amount you can take out pretax and send it to your 401k account to grow tax free.

Can I borrow money from 401k?
Yes, you may borrow it as a loan and pay predefined interest rates. There is no penalty if you repay it back and also when you borrow its not considered as taxable income. This is different than an IRA where you can't take out money except for certain special circumstances only. After age 59, you may borrow at will. The interest you pay on the money borrowed goes back in to your own account only..which is good. Unlike a loan from a bank, the interest goes back to the bank, here the interest you pay goes back to your own account which you will get along with everything else when you retire.

How is 401k different from IRA and why should I care?
401k often has a matching employer contribution. This is FREE money folks! Take it! Consider the following statement in your employee benefits while accepting a job offer:

"50% matching 401K contribution upto 5%".
What this means is that the employer will contribute 50% of whatever amount you set aside to deduct pretax from your paycheck to your 401k amount with a limit of 5% maximum of your yearly income.

John has the above benefit at his company and he earns $48k/year.  As stated above, the max he can contribute for 2009 is $16,500.
Lets assume he wants $6000/year or $500/month taken out from his paycheck for 401k. Now his beloved company has promised a 50% contribution upto 5% max. So the max that his company will match is 5% which is 0.05*48,000 which is $2400/year or $200/month.

John's yearly 401k Pool:

Lets say he retires after 30 years and assume he works at the same company and his pay and everything remains the same. Also assume his 401k investment earns him a measly 2%/year. Lets do the math:

Using the compound interest calculator the total works out to be a whopping $340,000! This amount is subject to taxes based on his tax bracket. If he takes out less then $67,900/year then he will pay only 15% taxes on it.
The above amount will be substantially higher if stock market takes off or his salary increases as he becomes a more experienced employee or if he contributes more to his 401k every year.

NutShell Bottom Line:
Don't ignore the power of compound interest! Any employer matching to 401k is FREE MONEY! Your account instantly goes up in value thanks to your employer.
Borrow money from your 401k  as a loan and pay interest, and as long as you pay it back there's no penalty or taxes.
No penalty-free withdrawal  for first time home buyers.

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