New to this blog? Check out all of my finance series here.
Whether you invest in index funds, other mutual funds, or individual stocks, you can get a tremendous tax advantage by investing your money through a bucket that the government calls “401(k)”. If you work in the public sector, a similar alternative available to you may be called “403(b)”, but the name is not as important as the concept. (For curious readers, the names directly come from the U.S. statutory tax law code that created this retirement plan option and defined its terms).
401(k) is a retirement account that you fund directly from your paycheck. To get started, simply set it up with your employer. The difference between a regular investment account and a 401(k) account is in how the money is taxed, as explained below:
- You can fund a 401(k) with your pre-tax money.
This is significant. Suppose that you earn $100 through your job, and you decide to invest it. With a 401(k), you can invest all $100. With a regular investment account, you have to pay taxes on it first (let’s say $20), so you’ll only have $80 left to invest. This initial difference, when invested with compound interest over time, makes a huge difference.
- Dividends and Capital Gains in your 401(k) account are not taxed.
In a regular investment account, dividend payouts from your stocks are taxed as ordinary income. Also, any gains in its market price of your stocks from the time you bought them to the time you sold them, are taxed in a form of tax called “capital gains tax”. However, 401(k) accounts on the other hand, will not tax you on dividends and market gains, so your money will grow tax-free.
- Contributions you make to a 401(k) are often matched by your employer.
If you are lucky enough to work for an employer who matches all or a portion of your 401(k) contributions, you have to take advantage of it. This is basically free money, and it’s not often that somebody will pay you free money, but this is one of those scenarios! Everybody should contribute to a 401(k) account to get the most match they can get from their employer before considering other investment options.
If all of this sound too good to be true, well, it’s all true. So far, you haven’t paid any taxes on anything! The government will eventually want to tax you on your money, so they will when you take the money out of your 401(k) account in retirement. At that time, the money you take out will be taxed as ordinary income. This is fine for most people, but if you expect to be in a higher tax-bracket in retirement, you also have the option, through a similar but different “Roth 401(k)”, to pay income taxes now, and take out the money tax-free in retirement.