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).
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.