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What do you need to know about 401(k) Plans?

What is a 401(k)? A 401(k) is the title of a tax code referring to a type of retirement plan. In the past, American companies offered their employees' pension plans. Due to the uncertain economy, mergers, and worldwide competition and a slew of other reasons, new and safe retirement savings plans have been developed to replace the pension plans of the past. Global competition has forced employers to lower the price of their goods and services. Unfortunately, to stay in business and retain the quality of their products, American companies have been forced to reduce the benefits and other financial compensation awarded their employees.

In 1978, lawmakers realized the economic changes in America called for some alternatives to pensions and other benefits previously provided by employers. Congress developed and passed the Tax Reform Act making it possible to create several tax deferred retirement savings plans and encouraging employees to, not only save for their retirement, but to also be rewarded through tax incentives to do so.

One of the more popular retirement plans, named for its section number and paragraph of the Internal Revenue Code is the 401(k). The plan allows employees to save for retirement by contributing monthly through their employers. The employee decides on a percentage of their income they want to contribute or save. Employers usually allow up to 15% or your salary to be contributed, and the IRS limits your total yearly contribution to $16,500 (in 2009) and a $22,000 cap for catch up contributions (made by employees over 50 trying to "catch up" their savings before retirement).

Your contribution comes out of your paycheck before taxes are deducted. Taxes on the contribution will be deducted upon the actual receipt of your money. Assuming you follow all the rules and stay in your plan until retirement, this usually means you will be in a lower tax bracket, (because you no longer have income) therefore owing less tax on the money than you would have if you had paid income taxes on your contribution when actually earned it.

As an incentive for you to contribution to a 401(k) some employers will match a portion of your contributions, meaning you will receive additional "free money"" at retirement. Of course, your employer has incentives from the government to participate in your retirement savings, but regardless of their reason, "free money" is "free money".

Usually you will have to work for the company for a pre-determined amount of time before they begin matching your contributions and then for an additional amount of time before that money is vested. That means you are not able to receive money from your plan until an additional pre-determined amount of time has passed. For example, you may have to work for a company for one year before they offer you a 401(k) plan. After the first year, you are able to contribute, then after another year, your employer will match a certain percentage of your contribution. That money will not actually be added to your account until you have worked for another specified amount of time, usually about five years. If you leave the company before retirement, you will not receive the portion that your employer has contributed, you will however be able to keep your 401(k) and "roll it over" to your new employers plan. There are other options available through most banks you can choose from before being forced to take payment of you savings and paying additional penalty fees.

If you were to take the payment of the money you have saved up until that point, you will not only have to pay the taxes on it, but also fees that have previously been agreed upon. You can however, loan yourself money, from the retirement plan, and will have to repay it back to your 401(k) plan. There are many stipulations to removing money from your retirement plan that should be explained to you before you begin investing or contributing to a retirement plan. Most companies have a specific human resources employee and other outside experts available to answer questions about your specific retirement plan before you actually begin contributing.

One nice thing about a 401(k) is you are usually able to choose what type of investment you want to make with your retirement money, for the more cautious investor and the more adventurous risk takers; there are plans available to fit your needs and desires. You can allocate a certain percentage to one type of "safe" investment, while also investing in a riskier venture, thereby diversifying your investment and making the most amount of profit or interest on your money that you would like. For example, you may want to invest in medical research, but would also like to risk some of your investment on an up and coming project you believe in, most plans make it possible to do both and allow you to be as involved or uninvolved as you wish to be. Investment counselors and bankers can usually help you with these decisions and at certain times of the year you can make changes to your plan to fit your needs. When you are younger, you may be able to take a few more risks with your investments but as you get closer to retirement, you may want to stick to a more conservative, proven plan. Regardless of which way you choose to go a 401(k) is an excellent idea for everyone. The money is withdrawn from your check before you have it in your hands, making it a great way to save money without having to put any thought into it at all. By simply having money deducted immediately by your employer, and in most cases matched by your employer, you are protecting while saving for your retirement. Your retirement years should be free from worry and by investing now in your golden years, you will be able to enjoy your retirement without the worry of being dependant on anyone else for your financial freedom.