401k Retirement Plans: What You Need To Know

401k plans are employer-sponsored retirement plans that allow workers to save for retirement through a tax-deferred account.

Many employers encourage employees to save by matching some or all of the funds that a person puts into his or her 401k retirement plan. A self-employed person can also set up a 401k plan to save for retirement.

About 401k Plans

401k retirement plans are the result of the 1978 Tax Reform Act that allows Americans to lower their taxes while they save for retirement at the same time.

The name 401k is due to the fact that this law is Section 401 Paragraph K of the Internal Revenue Code.

This plan went into effect in 1982 when the first taxpayers were able to take advantage of it. The plan with all of its regulations was published in 1991.

Types of Retirement Plans

401k plans are not the only retirement plans available to employees. There are also IRAs, SEPs and money purchase plans -- which are called "defined contribution plans" as the contribution amount is defined by the employee or employer.

Read: 401k vs. Roth IRA Retirement Accounts

Read: SEP IRA - A Way To Save Money On Your Taxes If You Are Self Employed

401K Contributions

As an employee, you tell your employer what percentage of your income you want to put into your 401k account.

Many employers set a maximum amount of contribution of around 15%.

The IRS sets the maximum limit at $15,000 a year.

Employees are not taxed on the amount that is withdrawn from their paycheck. This is why many people contribute to 401k retirement plans. Employers may also match all or part of your contribution. This makes 401k contributions difficult to walk away from.

401k Investment Options

A third-party plan administrator who, along with the employee decides how the money will be invested, then manages the money.

With a 401k retirement plan, your investment options are:

money market accounts

mutual funds

stocks

bonds

company stock

The plan administrator will inquire as to how aggressive you want your investments to be, and your options will be selected from there. As a rule, a person close to retirement would be less aggressive than a person who is far from retirement, as the chance of losing money is greater.

Here is a great illustration of how 401k retirement plans work.

Check out "3 Mistakes to Avoid With Your 401K." It has great advice on how to invest your retirement funds.

Cashing Out Or Borrowing Against Your 401k

Employees can begin to collect from their 401k accounts when they are 59-1/2. They are also able to borrow money from their 401k accounts. However, unless you are having a financial hardship, this is generally a bad idea.

The article 7 Reasons Why Borrowing From Your 401k Is Bad, Bad, Bad! warns against the many dangers of borrowing from your 401k account. The good news however, is that you will pay yourself back with interest. This comes with several disadvantages.

What Happens To Your 401k If You Change Employers?

When you leave your employer, you can:

Keep your money in your employer's 401k plan; or

Cash it out (with penalties if you are under 59-1/2); or

Roll it over into another 401k retirement plan.

Here's more about deducting from your 401k plan.

Recent Changes To 401k Retirement Plans

In 2006, Congress enacted a law stating that employees must opt out of joining 401k retirement plans instead of choosing to opt in. This law prevents lack of saving due to inaction.

Employees have 90 days to opt out if they do not want to participate.

The new guidelines allow employers to set default contribution levels for new employees of least 3% of compensation and allow for automatic escalation of a percentage point a year up to a minimum 6% by the 4th year of participation. Companies going this route are required to match these contributions -- at a rate of at least 2%, but not exceeding 3.5% annually -- and they must provide full vesting within 2 years.
Source: New 401k Plan Rewards You For Doing Nothing

Another recent change enables employees to use a Roth 401k, with the option of pre-tax contributions.

Why Wouldn't You Invest In A 401k Plan?

Is there any reason an employee might want to skip the 401k deduction? Not many.

Sure, it makes more sense to pay off high-interest debts before you begin saving, but to opt out of a 401k plan for this reason, you would need to be actively paying off your debts and have a date in mind when you will start making contributions to your 401k retirement plan.

You may want to opt out of a 401k plan long enough to decide how you want your money invested, but taking too long is the same as giving away free money if your employer is matching your investment funds.

If your employer does not match your 401k contributions and you've decided not to participate in a 401k retirement plan because you need every cent you make to live on, let's hope that this is a short term situation, and/or you are seeking better employment.

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