The 401(k), named for the IRS tax code that created it, is a savings plan offered by employers. There are variations on the 401(k), such as 403(b) plans (offered by employers in the health care and education fields) and 457 plans (offered to government workers), but they all work basically the same way. (401(k)s are the most common, so that's what we'll discuss here.)
"It's a tremendous vehicle and I would say that just about everybody should put as much as they can in their 401(k)," says Bryan Lee, a certified financial planner and President of Strategic Financial Planning in Plano, Texas.
The first benefit of a 401(k) plan is that you can save a portion of your income pre-tax. That means if you earn $50,000 and you save $10,000 in a 401(k), you're only taxed on earnings of $40,000. That could put you in a lower tax bracket.
Next, your account grows tax-deferred. That means the earnings aren't taxed until you withdraw money from the plan, presumably after you reach age 59 1/2. (The savings are supposed to be earmarked for retirement, so early withdrawals before age 59 1/2 mean you'll owe taxes and face a 10 percent penalty.) We keep saying age 59 1/2 -- there is an exception. If you're age 55 or older, you can be eligible for a so-called "separation of service" exemption. This means at age 55 if you're leaving your job you'd be able to start withdrawals from your 401(k) without penalty.
If you're not the most diligent saver and you tend to spend whatever money comes into your pocket, 401(k)s can put you on the right track. Because your contributions are taken directly out of your paycheck, you won't have a chance to spend the money first.
If you work for a generous employer, you may even get some free money in the form of an employer match. For example, as an incentive to save, your employer may offer to add $1 for every $2 you save, up to a certain percentage of your salary.
"The match is like free money," says Rick Fingerman, a certified financial planner with Financial Planning Solutions in Waltham, Mass. "Even if your investments don't earn any interest but they're giving you a match, that's money that you didn't have before."
But if your boss doesn't match contributions, 401(k)s are still a great bet because of the tax benefits, planners agree.
"Even if there is no match, you can't beat the tax-deferred savings," Fingerman says.
There are contribution limits to 401(k)s. In 2002, you can save $11,000 a year (not counting employer matches) into your plan, and the contribution limit will rise each year until it reaches $15,000 in 2006. (See chart on page 4.)
Should everyone contribute to their 401(k) or other employer-sponsored retirement plan? Probably, say financial planners. One reason not to invest is if the plan only offers very limited investment choices, such as company stock. That's because planners generally recommend you have no more than 10 percent of your entire portfolio in one stock. If you're only able to buy company stock in your 401(k), you'll probably be overweighted in that stock pretty quickly. You also have to remember that 401(k) savings are for the long-term, and you can't access them until age 59 1/2 without paying taxes on the earnings and a 10 percent penalty.
"This is money that needs to be for retirement," says Lee. "If someone is sitting there with $20,000 in credit card debt at 18 percent interest or they can't make their mortgage payment, they should without a doubt pay off debt first."
Continued on page 3: How IRAs Work