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(c) 2001, Fred McClure, All Rights Reserved


401(k) Defined

401(k) plans are retirement vehicles that allow employees to save for their own retirement. This type of plan was named for section 401(k) of the Internal Revenue Code, which permits employees of qualifying companies to set aside tax-deferred funds. It's no exaggeration to say the 401(k) plan is the most important national retirement effort since Social Security was introduced in the 1930s.

How It Works

The 401(k) mechanism is fairly simple. The plan is set up by your employer as a defined contribution retirement arrangement. That means you are the one who pays into the plan, although your employer and the plan provider who offers your 401(k) do just about all the work.

Your 401(k) contribution is automatically deducted from your paycheck each pay period. This money is taken out and invested before your paycheck is taxed. After you have decided what percentage you want deducted from your check, and how you want to invest it, your work is pretty much done.

Once the money is deducted from your paycheck, you can't spend it, but it is yours. It grows in your personal 401(k) account. Although you can withdraw the money for certain emergencies or in some cases borrow against your investment, the money is intended to stay in your account until you are at least 59 1/2.

While the investment is growing in your 401(k) account, you do not pay any taxes on it. When you withdraw the money at retirement, you pay taxes on the amount you withdraw from your account (so you pay taxes little by little instead of being hit with one big bill).

Employer Match

In some cases, employers make their own contributions to your 401(k) plan. This contribution takes the form of an employer match on your contribution. Usually the employer matches a certain percentage of your contribution. For example, an employer may elect to put in 50 cents for every dollar you contribute. That's an immediate return on your contribution, regardless of how you invest your 401(k) money.

Not every employer matches the employee contribution, but in some cases the company will match the employee contribution dollar-for-dollar.

What Do You Have To Do?

A 401(k) plan is an investment vehicle. Within the particular plan offered by your employer there are a number of investment options (each plan has a different set of options). These options may include mutual funds, guaranteed investment contracts (GICs) and, in some cases, stock in your employer. You decide which of these investments you want to buy, and how much of your total contribution you want to put in each.

This is a key difference between paying into Social Security and contributing to a 401(k). With Social Security, Uncle Sam decides how to invest your money. With a 401(k) plan, you decide for yourself. That may seem scary, but it gives you the opportunity to invest in a range of high-quality, professionally managed and potentially very lucrative investments. The Social Security Administration, on the other hand is legally obligated to stick to a very narrow range of investments.

How Do You Know Your Money Is Safe In Someone Else's Hands?

It is very easy to keep track of the savings in your 401(k) account. At regular intervals, you will receive an update telling you how your investments performed. Most plans also provide toll-free numbers and web sites you can access to keep track of your 401(k) holdings. You can move the money around within your plan easily.

A 401(k) is the easiest savings plan available to most American workers. It makes investing convenient and simple, and encourages you to save for the long term.


An individual retirement account (IRA) can help your retirement savings grow by allowing earnings to compound tax deferred until you withdraw them. There are several types of IRAs:
  • Traditional IRAs and Roth IRAs for individual investors.
  • Simplified Employee Pension IRAs (SEP-IRAs) and Savings Incentive Match Plan for Employees IRAs (SIMPLE IRAs) for self-employed persons, partnerships, or corporations that wish to sponsor a retirement plan for their employees.
Traditional IRAs Versus Roth IRAs

Under the Taxpayer Relief Act of 1997, individuals who have earned income and are within certain income limits may contribute up to $2,000 a year to an IRA.

Traditional IRA

If eligible under certain income limitations, you can deduct your contributions to a traditional IRA on your federal income taxes. Regardless, earnings on your contributions grow tax-deferred. Withdrawals are subject to ordinary income tax and possibly a 10% federal penalty tax if you are under age 59-1/2.

Roth IRA

Contributions to a Roth IRA do not qualify for an up-front tax deduction; however, you can withdraw your contributions and their earnings tax-free if the account has been established for five years. If you are under age 59-1/2 and have had the IRA for less than five years, your withdrawals may be subject to a 10% federal penalty tax.

Comparing Tax Benefits

The Roth IRA is particularly attractive for investors who fear that their tax rates during retirement may be higher than their tax rates today. In effect, the Roth IRA allows you to "lock in" your tax rate today.

On the other hand, if you expect your tax rate to be lower when you make withdrawals—a strong possibility during retirement—a traditional IRA could save you more in taxes, both today and in the future.


A Simplified Employee Pension–Individual Retirement Account (SEP–IRA) is an easy-to-administer plan that permits owners of small businesses and people who are self-employed to set aside money for retirement through tax-deferred investment accounts. A SEP–IRA is funded solely by employer contributions (which are tax-deductible as a business expense).

As a small-business owner:

  • You can contribute to each employee's account the lesser of $30,000 or 15% of an employee's compensation (in 2000 and 2001, up to a maximum compensation of $170,000). The compensation cut-off—which is indexed for inflation annually by the Internal Revenue Service—effectively limits your contributions to $25,500.
  • You must contribute the same amount for each employee as you contribute for yourself.
  • You can vary the contribution amount from year to year or even skip contributions in some years.
  • You must cover all employees over age 21 who meet a minimum income requirement and have worked for you during any 3 of the preceding 5 years. (The income minimum—$450 in 2000 and 2001—is indexed for inflation annually by the IRS.)
  • You can offer a SEP–IRA in addition to a qualified retirement plan.
  • You can establish a SEP–IRA by completing a one-page form; you don't have to register the plan with the IRS, and you must report to employees just once a year on contributions made to their accounts.

As an employee:

  • You are immediately 100% vested in a SEP–IRA. You can withdraw your employer's contributions at any time (subject to IRS rules, which generally impose ordinary income tax and a 10% penalty tax on distributions made before age 59).
  • You cannot contribute to a SEP–IRA yourself. However, you can make annual deductible or nondeductible contributions of up to $2,000 (or 100% of your compensation, whichever is less) to a traditional IRA.

As a self-employed individual:

  • You can contribute $30,000 or 13.04% of your net self-employed income (in 2000 and 2001, up to a maximum compensation of $170,000)—minus one-half of Social Security taxes due. (This limit is indexed for inflation annually by the IRS.)
  • You can make annual deductible or nondeductible contributions of up to $2,000 to a traditional IRA.
  • You can contribute to a SEP–IRA even if you also contribute to a qualified retirement plan.