Financial Advice from the Fiscally Impaired: The 401(k)

Behold the 401(k), that strange combination of numbers and letters that seems to be a staple in decent jobs and corporate workplaces. Everyone who's anyone has a 401(k)… but what exactly is it? And what can it do for you?

A 401(k) is essentially a retirement fund set up by an employer, wherein the money that an employee devotes is diversified among a variety of mutual funds, stocks, bonds, and money market funds. While it is possible that the stock market will crash, leaving employees fundless, governmental law mandates that employers diversify employee interests, creating a small-yield, low risk investment. Because most companies have better things to do than hire stockbrokers and investment professionals to watch over your money, the vast majority outsource to brokerages familiar with the work. The chances are also quite good that you'll have a participant-directed fund, which means that you can, at any time, control where your investments lie, in what percentages.

Trust me, it only sounds complicated. The first step you'll need to take is breaking the habit of storing your extra cash underneath the mattress - it's too easy to spend, the first place that robbers look, and it could be doing massive damage to your lower vertebrae. Don't have any extra cash, you say? Well, you might be surprised how little it takes to make a big difference with a 401(k).

So why do you want one? Easy:

Free money.

If your employer has a 401(k) matching program, which most do to some extent, then while you're putting money away into your account, your employer is also adding money, comparable to some percentage of your own investment. No matter how you slice it, this adds up to free money: if your employer is offering matching 3:4, then for every dollar you put in, your employer will add 75 cents. It might not seem like much to begin with, but after a while, it really adds up. Your first thousand invested dollars at this rate will yield 750 dollars of free money, not to mention all of the interest that will inevitably accrue because of it.

Compound interest.
While you're going to work everyday, the money in your 401(k) is making more money for you. Really! It's even making you more money when you're going to the gym, dodging the gym to see the new episode of Lost, when you're going out to eat with friends, even when you're out shopping. Yes, it's that simple. Once you have money in your 401(k), you money makes you money all the time. It may not be a large amount of money at first, but you're working with what's known as compound interest, which means that as your money makes you more money, the extra money that it's made you is in turn making more money, and so on. While the initial money that you've put into the 401(k) is taxable upon removal, this compound interest is not, which means, in short, that you get more free money, and everyone likes that.

Decrease in taxes.

A 401(k) can make your tax payments smaller by decreasing the amount of income that you state and bumping you down to a lower tax bracket. The amount of income you claim at the end of the year is the amount you make (net amount), minus the amount put aside (or "deferred") into your 401(k). Even if you have no interest whatsoever in long-term investment, retirement plans, or the like, if you're one of many Americans constantly struggling with the April 15^th deadline and trying to find a way to save money on your taxes, a modicum of investment could save you a great deal. For instance, an individual making 10,000 dollars would normally pay 10% in taxes, yielding $1000 in taxes come springtime. If you, instead, invested 10% of your income in your 401(k), then your recorded income would be $9000, and your taxes this year only $900. Sound too good to be true? Nope. It really is that easy.

Deterrent for spendthrifts.

If you can't get your hands on it easily, you can't spend it, right? The 401(k) is an excellent way to put money aside for your retirement or a major life event, or to provide security against future disaster (exemptions to the penalty tax for early withdrawal will be covered later). Because the money is automatically deducted from your paycheck every pay period, you don't have to rely on your own commitment to future fiscal security, and because you won't ever actually have your hands on the money, it's rather hard to miss. If you're truly addicted to having tangible control over your assets, you should opt for a participant-directed plan, which will allow you to move around your assets. This is the most common type of 401(k), and many employers offer online account management so that employees can move and distribute their assets among stocks, mutual funds, bonds, and money market investments as they best see fit. Keep in mind that all of this moving and trading, while still in your 401(k), is tax-free, which shows that it is the perfect type of plan to use for even the most adventurous of investors.

Okay, so you're worried about tucking your money away into some mystery fund somewhere, where you might forget about it. So you might not live to be 59 ½ and would like to have that money on-hand for something big you have planned coming up. Fret not-there are cases in which early withdrawal of funds is exempt from that nasty 10% excise tax they penalize you with for taking your money out early. You can take money out of your 401(k) without penalty if you are with drawing funds for:

-purchasing a new home or other primary residence

-avoiding foreclosure of a primary residence you already have

-making home repairs due to a deductible casualty loss, or a sudden loss not covered by your insurance (and usually caused by a natural disaster)

-funeral costs for those immediately linked to the employee (parent, spouse, child, or dependent)

-medical expenses for employee, spouse, or dependent which is not covered by insurance but can be deducted on a federal tax return

-paying expenses for secondary education for employee, spouse, or dependents, when accrued in the last 12 months.

Even if your needs are not penalty-tax exempt, if you're working with an employee matching program greater than 1:10, you'll still come out ahead. That means that after withdrawing the money, and paying regular taxes on it (because this part of your income hasn't been taxed before), you'll still be able to enter into that new phase of your life with all your saved cash in hand (and possibly a good deal extra).

In a risky world of financial instability, the 401(k) is a rarity-a truly safe investment. Now that you know why you should have one, and how to set it up, you've made the biggest steps towards financial stability.