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The 401(k) Retirement Plan: An Introduction

What is a 401k? Basically, it’s a retirement investment account funded by direct tax-free withdrawals from your paycheck. If your company offers a 401k, you need to have one…

What is a 401(k)?
A 401(k) retirement plan is, very basically, an investment account funded by direct withdrawals (called “deferrals”) from your paycheck. The largest benefit of a 401(k) is you do not pay any federal taxes on the money you save, or earn in interest, until you make a withdrawal.

While 401(k) retirement plans are sponsored by your employer and managed by a third party (Fidelity Investments, for example), a 401(k) is a self-directed account. You control how much (if any) money you want to contribute to your 401(k) and your employer automatically takes that money out of your paycheck to deposit in your plan. Your employer may match a certain percentage of the money you contribute to the plan, up to a limit, or may make regular contributions based on your salary whether or not you contribute your own earnings.

Why contribute to a 401(k)?
Just 50 years ago, any decent job offered a pension that guaranteed a percentage of your salary (based upon years of service) between your retirement and the day you died. On top of Social Security, which provided a similar benefit to everybody, most hard-workers could look forward to a relatively comfortable retirement without a second thought. Today, this simply isn’t the case.

Pension plans worked when the average retiree lived for just five or ten more years. Fortunately for us, we live a lot longer today. Unfortunately for employers offering pensions (and employees counting on them), those funds have been eaten up by current retirees. Even more frightening, the federal government has acknowledged the same thing will happen to Social Security. To those working today this is a double slap in the face. While existing retirees’ benefits are coming out of our paychecks each month, the likelihood we will receive similar benefits when we retire is dwindling.

With disappearing pension plans and the erosion of Social Security, young workers have two options: work until you die or save for retirement yourself. For most, a 401(k) retirement plan is the best choice. Why?

Benefits of a 401(k) retirement plan
401(k) plans offer a number of benefits that you would not get through just any investment account. They include:

Tax deferred savings – Your 401(k) account is not subject to federal taxes until you make a withdrawal. That means that your investments grow tax-free for decades. The catch? If you withdraw from your account before retirement the IRS will hit you up for its share – up to 28% plus a 10% early withdrawal penalty if you withdraw before 59 1/2. There are limited exceptions for 401(k) hardship withdrawals and 401(k) loans.

Employer matching – Though not mandatory, most employers provide some sort of matching contribution or profit-sharing contribution to your 401(k) plan. When paired with a regular employee contribution, such contributions can effectively increase your salary by several thousand dollars a year.

Large deferral limits – As of 2006 the IRS allows employees to defer up to $15,000 or 100% of earnings, whichever is less, into a 401(k). Participants age 50 and over can also make “catch-up” contributions up to an additional $5,000 in 2006.

401(k) rollovers – Thanks to the 401(k) rollover; a 401(k) retirement plan is highly portable. As it is unlikely you will work for one employer throughout your career, it is possible to “rollover” your 401(k) into a new company’s plan or an Individual Retirement Account (IRA) without incurring any tax penalties.

Start contributing today!
There is no reason not to take advantage of a 401(k) retirement plan if your company offers one. Read more on Money Under 30 to learn why you must start saving early, learn about unvested money, or use a 401(k) calculator to determine how much you need to save.

About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.