Today’s question is in regard to 401(k)s. Specifically, why are 104(k)s important? They’re important for two big reasons.
Number one, 401(k)’s are important as a mechanism for someone to save and build up a nest egg that they can use when they retire and replace their paycheck. It used to be that you would work for an employer, maybe for your whole career. You retire, and they would provide a pension for you. For many people, pensions and Social Security are really the core of their retirement income. Now, pensions are few and far between, so it’s more incumbent upon people along the way while they’re working to be saving for retirement and build up a nest egg for themselves. Then, in addition to social security, they can replace that paycheck and have income out of that in retirement.
The second reason why 401(k)s are important are for tax purposes. Generally, when someone puts money into a 401(k), they’re deferring taxes. Meaning, they’re not paying federal or state taxes on the income that they’ve deferred into the plan and they defer those taxes until later on down the road. They also get tax deferred growth of that money. You might be investing in various mutual funds, stocks, things of that nature, inside of your 401(k) or even IRA. Along the way, maybe those investments produce returns, grow and produce dividends and things like that, but you’re not taxed on that until you ultimately start taking money out of the 401(k) or IRA.
There are other ways to contribute to a 401(k), on a Roth or an after tax basis, which is going to be a little bit different. That’s a topic for another one of these questions later on down the road. Again, there are two big reasons 401(k)s are important: one, as a mechanism to build up retirement funds to use down the road, and two, for immediate tax benefits.
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