When taking your first steps into the investment world it is important to approach with caution. As you start out, there is no sense in making life too hard on yourself. You would never jump into the deep end of the pool if you didn’t learn to swim first, would you? There are many ways for you to get started in the investment world. When looking at different avenues of investing, you should prioritize how you invest your money.

The What:
A great place to start is through an employer sponsored retirement plan, such as a 401k plan. A 401k plan is a group savings vehicle, set up through your employer, which allows you to automatically deduct a certain portion of your salary and have that money invested. 401k plans have many tax advantages and also offer an affordable way to take your maiden voyage into the investment world. This is because, many times, companies will pay some or all of the start-up costs associated with their retirement plan. However, the cost of setting up your investment account is not the only cost benefit to a 401k plan. Over 25% of all 401k plans also offer employer contributions coming in the form of “matching” contributions. This means that your employer will match a certain percentage of what you contribute to the plan as an incentive for you to save money. It is FREE MONEY!! This cannot be emphasized enough  if your employer has a 401k plan that offers matching contributions, make sure you are contributing at least to the matching limit. For example, let’s assume your company is matching 50% of what you put into your 401k plan up to a maximum of 6% of your gross salary. That means that for every dollar you save in the 401k, not exceeding 6%, your employer is putting in an additional $0.50 cents. So, if your salary is $30,000 and you decide to put away 6%, your contribution would be $1,800 for the year ($30,000 * .06). Your employer would then contribute an additional $900 ($1,800 * .50). That is a guaranteed 50% return on the first 6% you put into the plan . . . you can’t beat that!!

The Why:
Cost is not the only benefit of using a 401k to begin your investing career; there are also tax benefits as well. First of all, money that goes into your 401k may not be taxable by the federal or state government as income. For example, take the same person making $30,000 per year and contributing $1,800 of that into their 401k plan. The $1,800 that goes into the 401k is exempt from federal and state income tax for the year that you made the contribution. The federal and state government is only going to tax you like you made $28,200 ($30,000 – $1,800). Now let’s say that this person pays a total of 25% in both federal and state income tax. This being the case, the $1,800 that was saved by using the 401k only impacts this person’s take home pay by $1,350 ($1,800 * [1-.25]). This allows you to save a good chunk of change without having to give up too many nights out on the town. When you decide to retire and start taking money out of your 401k is when government will tax the withdrawn money as if it were income. So if you saved enough over your working life to accumulate $500,000, that doesn’t necessarily mean that you would have $500,000 to fund your retirement. Instead, this $500,000 would be taxed like income as the money comes out. The benefit comes by producing investment earnings on your dollars without those earnings being diluted by paying taxes each year. This sounds pretty good, so what is the catch? There really isn’t one, but the tax benefit of your contributions doesn’t come without making some minor sacrifices. Remember that when you use your 401k plan, you are saving for retirement. 401k plans are not a savings account that you can take money out of any time you want to buy something new. In order to take your money out of the 401k plan you need to wait until you hit age 59 ½ before the money is free of any early withdrawal penalties. If for some reason you decide to take your money out prior to hitting the ripe old age of 59 ½ you will pay Uncle Sam an additional 10% penalty deemed an early withdrawal penalty.

The Advantage:
This pre-tax, or traditional, way of saving through the 401k had been the most customary way of saving for about 25 years. However, in 2006, the government allowed plans to add a Roth component (The Roth component is available to 401k’s, but not mandatory and may not be offered in your 401k plan.) Roth refers to the tax status of the dollars going into the 401k plan. We talked about money coming in and being exempt from federal and state income taxes, but being taxable when you take the money out at retirement. The Roth differs from the traditional 401k contributions in that any contributions made in the Roth state are not exempt from federal and state income taxes today. However, these contributions still grow year over year without being taxed. The difference is when you take the money out at retirement, everything you invested into the Roth account and any earnings that the money has received are not taxable at retirement. For instance, in the example we used above with the individual earning $30,000 per year and contributing $1,800 into the 401k, if the contributions made were Roth contributions he or she would pay income on all of the $30,000 earned for that given year. Again, the benefit of using the Roth 401k comes at retirement when you withdraw your savings and do not have to pay taxes on any of the money coming out, assuming you have hit age 59 ½ and have been invested for 5 years. So in the example of an individual with $500,000 of accumulated savings, assuming all savings were Roth savings, he or she would not have to pay any taxes on their $500,000 as they withdraw the money at retirement. Where a person should consider using the Roth is when he or she has a long time horizon and thinks that they will be in a higher tax bracket at retirement than they are currently in today. This is because the tax benefit you will receive from having non taxable income at retirement may outweigh the tax benefit you would receive today by not having to pay income taxes on the dollars going in.

The Wrap-Up:
Sound confusing? That’s because it is. Here is the bottom line; people do not save enough money for retirement. The decision to make your contributions as traditional (pre-tax) or Roth (after-tax) is not nearly as important as making the decision to use your 401k plan. The government offers these tax benefits to 401k participants because they are aware of this fact. Currently 40% of people are not saving for retirement at all. Sure, this may mean that a person is able to go out on the town one extra night a month or drive a slightly nicer car, but that doesn’t help at retirement when he or she wants to quit working but can’t find a way to afford the lifestyle that he or she has grown accustomed to. No one wants to work forever, and if you are a person that does, more power to you, but for most of us that is not the case. DO NOT let the complexities of 401k plans be the shark that keeps you out of the ocean. If you take anything from this column, it should be this; 401k plans offer an extremely beneficial and relatively easy way to begin your investing career. Take it upon yourself to take advantage of a 401k plan if you are lucky enough to work for a company who offers this benefit to you. And for crying out loud, if your plan offers a matching contribution, contribute at least enough to get the full company match!

John R. Ryan is the Regional Marketing Director of John Hancock Retirement Plan Services

Disclaimer: Before investing one should consult a registered financial advisor to obtain further information about investments and financial products.