A Simple Guide to 401(k) Plans

Gone are the days when you finished your career with a gold watch and a pension. Now, the vast majority of American workers are expected to fund their own retirement. Of course, that doesn't mean that the government and most companies sit idly by while the average worker has to slave away towards a futile goal. Instead, the government created a great little account called a 401(k), and employers jumped on the bandwagon.

You've probably heard about a 401(k) plan, and you might even be enrolled in your company's plan. But you might also still be pretty clueless when it comes to this little retirement vehicle. So here are the basics about how 401(k) plans work.

1. It can mean free money. Most employers will meet your contributions to your 401(k) plan, up to a point. This is equivalent to your employer essentially giving you an extra check every year. At the very least, you should contribute to your 401(k) up to the point of your complete employer match. It's an easy way to get a guaranteed 50-100% return on your money; you won't find that anywhere else.

2. You won't miss the money. 401(k) accounts are funded with pre-tax money, which means that the money that you contribute is not taken dollar-for-dollar out of your take-home pay. If you are in the 25% tax bracket, for example, every dollar you contribute to your 401(k) will only reduce your paycheck by $0.75. Live in a high-tax state? Then your paycheck will be reduced even less. Not only that, but contributing enough to your 401(k) plan could bring you down into a lower tax bracket, by reducing your taxable income.

3. You might already be enrolled. Companies are increasingly enrolling employees automatically in their 401(k) plan, though the contributions are usually too low. The average contribution for automatic enrollment is 2% of the worker's salary, with an annual increase of 1-3%. That's better than nothing, but it would be better still if you sign up yourself to contribute 6% or more with annual increases.

4. You can take it with you. And, in many cases, you should. When you change employers, you have three options: you can leave your 401(k) with your old employer (if you have at least $5000 in it; otherwise, your former company can force you out); you can roll your balance over into your new company's 401(k) plan; or you can roll your balance over into an IRA at a brokerage or mutual fund company. Unless your old or new plan offers outstanding investment options, rolling over into an IRA is usually best, because you can invest in virtually any stock, bond, mutual fund, or ETF. Most 401(k) plans, on the other hand, have only a limited number of investments you can choose from.

5. Your money can grow tax-free. This is, of course, the main draw for 401(k) plans. Your money can grow completely tax-free until you withdraw your money in retirement, where it will be taxed. This means that you will not have to pay taxes on capital gains or dividends until you take money out of your account. The power of compounding makes this an especially great deal. Compounding means that your gains will produce more gains as time goes on. Because they're not being taxed, your gains are free to grow as much as possible. Of course, this also means that when you eventually withdraw your funds, they will all be taxed as regular income, as opposed to at the currently lower capital gains rate. But only part of your nest egg would have been taxed as capital gains, and compounding can be a far more valuable tool when you're looking to the long-term.

6. It is not an easy loan. Just because you can borrow against your 401(k) balance doesn't mean that you should. For one thing, you'll have to pay the loan and interest back with after-tax money. That money will be taxed again when you eventually withdraw it in retirement. Another reason not to borrow against your balance is that, if you leave your job for any reason, you'll be expected to pay the balance back immediately. Most importantly, though, you'll lose precious time and compounding while your money is out of your account.

7. It's not just traditional anymore. As of January 2006, some employers have begun offering a Roth 401(k), which works similarly to a Roth IRA. While the information above is mainly geared towards traditional 401(k)'s, a Roth may be a good idea if you are very young, in a low tax bracket, or planning to spend as much in retirement as you do before, a distinct possibility if you plan on pursuing expensive hobbies or extensive traveling.