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Maximize Your 401k

There are various retirement accounts available to people. The best accounts offer tax advantages. Some of the retirement accounts that offer tax advantages are: 401k, 403b, and IRA. 401k, 403b, and some IRA accounts offer tax deferred growth. What this means is that you contribute pre-tax money into the accounts. Some IRA accounts, including Roth IRA accounts, have other advantages like tax free withdrawals.

What are the advantages of tax deferred growth?
  • Reduce your adjusted gross income
  • Pay less taxes
  • Possible move to a lower tax bracket
  • Increase your investing power
When you spend after-tax money, a dollar actually is worth less than it was before taxes. For example, if you have one dollar, after tax, you may have actually earned $1.20, and 20 cents went to taxes. When you are using pre-tax money, the dollar you invest may have been worth only 82 cents with after-tax money. This increases your investing power, and reduces your overall tax burden. However, you must remember that you will be paying taxes on the money when it is withdrawn. This usually works out well, however, because you typically earn less in retirement. So, when you retire, you can typically expect to be in a lower tax bracket, meaning you will pay less taxes, overall.

There are other great reasons to invest in 401k accounts. Typically, your employer will match your contribution, at some level. For simplicities sake, let's say that John earn $100,000 per year. John's employer, Acme, offers a 50% match on his 401k contributions, up to 3%, and a 25% match on contributions beyond that, up to 6%. So, if John contributes 3% of his salary into his 401k account, he will invest $3,000. John's employer, Acme, will match his contribution by 50%, or $1,500. This means that the $3,000 that John invested is already worth $4,500, assuming he is 100% vested, or will become 100% vested. That is a 50% return, on day one. You will be hard pressed to beat a 50% return.

In many instances you are allowed to contribute up to 15% of your earnings into your 401k. Many financial advisors will suggest maxing out your contributions. A guaranteed suggestion will be to contribute as much as your employer will match, at a minimum. That means that a financial advisor will recommend for John to invest a minimum of 6% of his earnings, as his employer will match up to that amount. This is a good idea, no matter your financial situation. If you are currently trying to reduce your debt, I would recommend that you do invest up to the match, and no more, as you need to focus on your debt reduction. If you are in a two-income family, and you comfortably live within your means, I would suggest maxing out your 401k, if you can still afford to invest elsewhere.

I will advise you to not max out your 401k if you can not afford to invest in other areas. Why? Because you must remember that your 401k is not very liquid. You must wait for you retirement to come around in order to withdrawal funds without penalties. If you want to attain financial freedom before you hit your retirement age, you will definitely need to invest in areas that allow you more convenient access to your earnings. You could invest in rental properties that can give you immediate, but small amounts, of income. You could invest in certificate of deposits, mutual funds, stocks, bonds, or anything that has a decent return. I would shoot for things with a return of nearly 10%. I would avoid investments with returns of 3% or less, as that is at or below inflation.

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