A 401k is a retirement savings account established by an employer in which both the employer and employee can contribute. The IRS regulates these accounts with certain tax rules and contribution guidelines. With investments made with pre-tax dollars and "free money" in the form of employer matches, the 401k represents one of the best options available to grow a nest egg for retirement.
How Do I Contribute to the Plan?
Your employer makes regular deductions from your paycheck in the amount of your choosing. The money is "pre-tax," meaning it goes into the account before any tax is withheld and is not counted against your taxable income for the year. In addition, your employer can make contributions up to your amount, matching and in some cases doubling your own investment.
How Much Can I Contribute?
The IRS sets the rule for maximum contributions. Each year, the amount rises with the index for inflation. In 2011, for example, your maximum contribution was $16,500; in 2012 that limit rose to $17,000. The IRS also allows "catch-up" contributions over and above the annual limit for those aged 50 and above. This provision allows those who haven't saved for retirement years when they were younger to get a retirement account established and growing as quickly as possible.
What am I Actually Investing In?
The plan manager will offer a selection of investments, usually including mutual funds, money market funds, savings certificates, and in some cases, individual stocks and bonds (which you can buy and sell). You direct the mix of investments, with most financial advisers recommending that you turn to safer, more conservative investments as you get closer to retirement.
When Can I Withdraw the Money?
The 401k will have restrictions on withdrawals, which you should be well aware of before you begin participating. As you gradually become "vested" by putting in more years of employment, the percentage of employer contributions you can retain in the plan increases. In addition, any withdrawals you make before you reach the age of 59-1/2 may be subject to a 10 percent early withdrawal penalty levied by the IRS (on top of income taxes on the plan's earnings).
What if I Lose My Job?
If you lose your job or your employer goes out of business, the 401k plan remains your property, which you can then transfer to another account such as an Individual Retirement Arrangement or IRA. You have a limited amount of time to make this rollover, however, otherwise the IRS will assess the penalties taxes for an early withdrawal.