One of the great safety net in modern times is the Social Security system. It’s a fantastic retirement income system that has enabled many retirees to live out their golden years in a dignified manner. But Social Security was never meant to be the sole source of income for retirees. But many people don’t understand that Social Security was never meant to be a seniors sole source of income. It was meant to supplement their existing earnings from pension payments and other investments. Recognizing that people were not saving their money as diligent as they perhaps should, the government began to create incentives to help them save. The 401k plan came about as a way  to encourage people to save money for their retirement years by giving them certain financial incentives.

So, exactly what is a 401k retirement plan? A 401k plan is a retirement plan for employees of companies. The company administers the plan but both employer and employee are allowed to contribute to the plan. The essential, and huge, advantage of a 401k plan is that you are able to save using pre-tax dollars. That is, the money that you earmark for the 401k is placed into the plan before it is taxed. In addition, the money is able to continually earn untaxed interest on your donations until you withdraw the money - typically at retirement. And even then, only the money that you withdraw from the fund is taxed. Presumably, since you’ll be at a lower income level when you retire, the amount of money that you will be taxed will be lower as well.

The most amazing part of a 401k plan is it’s tax free compounding effect. This can literally result in an ultimate retirement income of thousands or even hundreds of thousands of dollars more than the same investment placed in a taxed investment vehicle. For example, assume that you are in the 25% tax bracket and have $1000 invested in an investment vehicle that is paying you 8%. At the end of the year, you have earned $80. But after taxes, you have netted only $60 - effectively giving you a real 6% return on your investment instead of 8%. If your investment vehicle had been a 401k, however, you would have paid no taxes at the end of the year. Thus you would have netted the full $80.

You can’t escape taxes. You will ultimately end up paying them. The difference, however, is that meanwhile, you have the full use of all profits derived from your investment and are able to let them compound unencumbered. If you invest more than $1000 a year in your 401k plan, which many people do and if your investments average more than 8% a year, you could realistically come out thousands of dollars ahead when your retire.

Some employers entice workers to join their company by touting their generous 401k packages. In better economic times, it was not unusual for a company to match the employee’s contribution with an equal amount of their own. For example, if you gave $100 to your 401k plan, they would match it with $100 from their pocket. A great way to make money on your investment.

In the current recessionary economy, however, those generous packages have become harder to come by. In addition, fewer companies than ever are offering pensions to their employees, making it even more important that you take control of your own retirement plans. So even if your company has a 401k plan, but no matching program in place, you should still definitely take advantage of it. When you retire, you’ll be glad you did.

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