What is a 401(k) Plan?

401(k) retirement plans can make the difference between a financially secure retirement and the possibility of running out of money. It's important to understand every aspect of how your 401(k) plan works, whether you're just getting started or you're already retired.

A 401(k) plan is an employer sponsored retirement savings plan.  401(k)s are largely self-directed: You decide how much you would like to contribute, and which investments from among those offered by the plan you would like to invest in. Traditional 401(k)s are funded with money deducted from your pre-tax salary. Your earnings are tax deferred until you withdraw your money from your account. Roth 401(k) contributions are made after-tax, but qualified withdrawals in retirement are free of federal income tax.

Enrolling in a 401(k) plan gives you a head start on your retirement planning. A 401(k) not only provides a mechanism for saving, but also helps to reduce the income taxes you owe now and allows the money in your account to compound tax-deferred. That means that the earlier you enroll and the more you contribute, the greater chance you’ll have of amassing a substantial retirement account.

Any money you contribute to a salary reduction plan and the earnings those contributions produce always belongs to you - though you usually must change jobs or retire to withdraw or move the balance. In contrast, you don't have a right to the money your employer contributes to your account (or the earnings made from those contributions), or makes to any other retirement account for you, until you are fully vested, or have full legal rights to your account. Vesting is determined by time on the job.

In plans that offer loans, you may also be allowed to borrow money from your account. (federal law caps the amount you can borrow as either 50% of the account value or $50,000, whichever is less) with a five-year repayment period. The law also requires that you pay market interest rates. That means the rate must be comparable to what a conventional lender would charge on a similar-sized personal loan. Of course, if you leave your job, the loan may have to be repaid immediately.

The funds in a 401(k) plan are portable. When you leave your job or retire, you can move your funds or take a taxable distribution. However, if you leave a company before you are fully vested, you will be allowed to take only the funds that you contributed yourself plus any vested funds, as well as any earnings that have accumulated on those contributions.

Within certain limits, the funds in your 401(k) plan can be rolled over directly to your new employer’s retirement plan without penalty. Alternatively, you can roll your funds directly to an individual retirement account (IRA) instead.

You must begin taking required minimum distributions from 401(k) plans no later than April 1 of the year after you reach age 70½. Distributions from regular 401(k) plans are taxed as ordinary income and may be subject to a 10% federal income tax penalty if withdrawn before age 59½, except in special circumstances such as disability or death.

A 401(k) plan can be a great way to save for retirement, especially if your employer offers matching contributions. If you are eligible to participate in a 401(k) plan, you should take advantage of the opportunity, even if you have to start by contributing a small percentage of your salary. This type of plan can form the basis for a sound retirement funding strategy.

(Click here for more information:  Smart 401(k) Investing)

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