When Does it Make Sense to Participate in a 401(k) Plan

More than likely it makes sense to participate in your company's 401(k) plan, but you need to find out more information about the plan first. Ask a Human Resources representative for more information about the plan, or talk to a co-worker who has been employed there for a while. Most importantly, find out if your employer offers matching contributions. This is free money that is offered by employers to encourage participation in the plan.

Funding your 401(k) account is the perhaps the most important investment step that you can make. Not only do many companies offer to match your contributions to these accounts, but 401(k) accounts have the important characteristic of being tax deferred, meaning that all interest and growth of principal is not taxed until the monies are withdrawn. In addition, all contributions used to fund the account are made with pre-tax dollars.The most beneficial aspect of a 401(k) is if matching contributions are offered by your employer. Matching contributions typically are a percentage of the amount the employee contributes (for example 25%) or a percentage of annual salary (for example 3% of your annual salary is contributed to your account) with a cap at a certain amount (say $5,000). Meaning that if the employee contributes $10,000 to their 401(k) account for the year, the company will contribute $2,500 to the account as well. Or if your yearly income is $50,000, the company will contribute 3% of your salary, or $1,500. Read your companies' retirement plan carefully, as typically the company contribution will vest over several years of service.

Contributions to a 401(k) are made with pre tax dollars, meaning that all monies are made before they are subject to federal, state, unemployment, and disability taxes. That means that you are able to contribute a higher amount because your gross earnings have not yet been taxed.

In addition to their other beneficial qualities, 401(k) accounts are tax deferred, meaning that all earnings in these accounts are not subject to tax until they are withdrawn from the account. Any interest, dividend, or growth of your contributions are not taxed, and the magic of compounding interest allows for the amount in your account to grow rapidly.

When faced with a decision, it will almost always benefit you to fund the account that is tax deferred. When you combine the tax deferred qualities of a 401(k) account, along with the ability to contribute pre-tax dollars and company matching amounts, 401(k) accounts should be one of your first investment choices. Once you have contributed the maximum amount to your 401(k) account, then it is time to consider other investment vehicles.