A great way to save money and defer taxes is with a 401k plan. We consider how to invest your 401k. The limits on how much you can invest tax free each year in a 401k are higher than with an IRA. In the USA a 401k plan is a tax-qualified, defined-contribution pension account defined in subsection 401(k) of the Internal Revenue Code. Money is deducted from a paycheck before taxes and commonly is matched by a contribution from the employer. As of 2013 the maximum pre-tax annual amount allowed for a 401k was $17,500. This money can be invested in a variety of ways and can grow tax free over the years only to be taxed when the individual decides to withdraw, typically at retirement. In some 401k plans a post-tax contribution is also allowed. Post-tax contributions also are allowed to grow within the 401k account tax free until withdrawal. Make sure that you understand how your 401k works and get competent tax advice if you are confuses. In this article we have a few ideas about how to invest your 401k. Remember that when you take your money out of your 401k it is taxed as ordinary income so your retirement years when you have no salary are the best times to withdraw your money.
How to Invest Your 401k: How It Works
When you put your money in a 401k or other tax deferred plan you are dealing with marginal tax rates. This has to do with the amount of tax paid on an additional dollar of income. The marginal tax rate for an individual will increase as income rises. When you put money in your 401k you are taking money that you would invest or save anyway. And you are not taxed for this last bit of income so long as it goes into your 401k. That can be a savings of around 25%. Then the appreciation of your investment in the 401k is allowed to increase without yearly taxes. For example, if you have a dividend stock in your 401k portfolio you will not be taxed on the dividends over the years. Likewise, if you buy a growth stock and then sell it after a big run up you will not pay capital gains on the stock while it is in your 401k. When you do pay taxes, it will be when you are retired and typically in a lower tax bracket. The exponential growth of your investments is substantially better when not taxed until it is taxed just one time on withdrawal. This is why a 401k is a preferred way to save.
How to Invest Your 401k: Best Vehicles
Always remember that how you invest your 401k versus investments with other vehicles has to do with the tax advantages of deferring taxes until after an investment has exponentially appreciated in value for many years. As an example you would not want to put municipal bonds in a 401k because they are already tax advantaged. In our most recent articles, Invest Your Money, we note that you should pay off credit card debts, purchase a home and have a rainy day stash the bank before thinking about investing. To a degree this also applies to the first years of how invest your 401k. Thereafter think of long term growth stocks, hot stocks that you can buy cheap and sell when then they run up and avoid the immediate tax consequences and stocks with a substantial margin of safety. This is because the worst thing that can happen is that you play with your 401k and lose everything. The way to save money on paying taxes on investment income is decidedly not to have any 401k withdrawals on which to pay taxes.