How Does a 401(k) Plan Work?

Of all the retirement planning options that are available, 401(k) plans may be one of the best programs for accumulating retirement funds.

Unlike a taxable savings vehicle, a 401(k) plan allows you to make annual pre-tax contributions of up to $15,500 in 2007.  Also, individuals aged 50 and older may make additional "catch-up" contributions of $5,000 to 401(k) plans in 2007.  And pre-tax contributions are much better for savers than after-tax contributions. For example, if you are in the 28 percent federal marginal tax bracket, it effectively costs you only $72 of spendable income to save $100 for retirement. And it works out even better for those in higher tax brackets.

And like other qualified retirement plans, a 401(k) allows your money to grow tax deferred. This enables you to build capital significantly faster than similar investments outside the shelter of an employer-sponsored plan.

But that’s not all. A 401(k) plan offers some additional benefits that make it particularly attractive.

Portable

A 401(k) plan is portable. Unlike some employer-sponsored retirement plans, you can take your 401(k) plan with you when you change employers.

Within certain limits, the accumulated funds in your 401(k) plan can be rolled over into your new employer’s retirement plan without penalty. If your new employer’s retirement plan doesn’t allow such transfers, you can roll over your fund into a traditional Individual Retirement Account.

Considering that the average worker changes jobs five to seven times during his or her career, this can be an important advantage.

Employer Matching

Many employers offering 401(k) plans to their employees match contributions. For example, employers may add an amount for each dollar you contribute, up to a certain percentage of salary. That’s an automatic return on your investment.

Over the long term, matching contributions enable you to accumulate more retirement assets than plans based solely on employee contributions.

Investment Flexibility

A 401(k) plan can also provide a great deal of flexibility. According to Hewitt Associates, the average company offers nine investment options with its retirement account. Among these choices, you’re able to select how your retirement fund will be invested. Most plans offer a number of stocks, bonds, and money market funds, in addition to guaranteed investment accounts. Many publicly traded companies also give you the opportunity to place a limited amount of your retirement money in the company stock. You can be as aggressive or conservative as you wish depending on how you allocate your money among the investment options available.

Final Analysis

If your employer offers a 401(k) plan, you should carefully weigh the benefits in light of your financial situation. A 401(k) plan can form the basis of a sound retirement planning strategy.

Withdrawals from 401(k) plans prior to age 59½ are subject to a 10% penalty tax, with few exceptions, as well as ordinary income tax.