401(k) Basics

If your company offers a 401(k) plan, you should take advantage of it. Since their inception in 1981, 401(k) plans have made saving for your retirement particularly easy, provided the company you work for offers such a plan. The idea is that money will be deducted from your weekly salary and put into your own retirement plan. Typically, you'll need to work at the company for a specified amount of time before you'll be allowed to participate. There may also be stipulations regarding the number of hours you work in a week.

Once you are in the plan, you can contribute up to a specified amount annually. The key benefit of a 401(k) plan is that your employer will often match a certain percentage of your contribution, often as much as 50 percent of each dollar, and up to six percent of your salary. This is essentially free money for the employee.

Within the plan, you'll be able to choose from a number of investment options. Your plan will generally provide a range of different fund choices. You can also make changes in how much you contribute and where the money is invested within the plan. As is the case with any investment plan, you need to plan your asset allocation and diversify.

A 401(k) also helps you reduce your taxable income. Contributions are deducted from your pay before taxes are withheld, reducing your gross, taxable income. As a retirement plan, you save money because there is tax-deferred growth, meaning the money in the plan compounds without being taxed each year.

Since the 401(k) is a retirement plan, you need to leave the money in the plan until the age of 59½. If money is withdrawn earlier, you will generally pay taxes plus a 10 percent penalty. There are certain hardships, such as disability, that allow for taking money out of a plan before age 59½, and sometimes first-time home buying can be a reason to withdraw money without penalties. You'll have to read the fine print of the plan carefully, as the details will vary from plan to plan. If you really need money, many plans allow you to borrow some portion of the money in your plan. However, you usually have to pay it back with interest.

Should you change jobs, you can, by law, roll over the money into the 401(k) plan of your new employer. You can also roll over the money into an IRA. You need to do a direct trustee-to-trustee transfer to make sure you are not taxed on the money.

When you reach the age of 59½ you can start withdrawing your money from the plan or roll it over into an IRA. There are options for receiving distributions, which can be in a lump sum payment or through periodic distributions. Until the age of 70½, you're not mandated to take the money out of the account. At that point you are required to begin taking mandatory annual distributions from your 401(k) plan.

In sum, 401(k) plans are excellent retirement vehicles in which your money can grow without being taxed. If your company matches your contribution, you are earning extra, tax-free income.