401(k): What It Is and How It Works
A 401(k) plan is a savings plan that allows you to divert a portion of your income into a tax-sheltered savings account, which accumulates without your having to pay income taxes on it.
This program falls into the defined contribution retirement category because the law defines, or limits, how much you can contribute to your 401(k) plan as a percentage of your income. The plan sponsor — your employer — must make sure your contributions comply with the law and the specific plan. In 1999, for example, the maximum amount you were allowed to defer from your income for the 401(k) plan was $10,000 or 25 percent of your pay, whichever is less, per year.
Some employers encourage you to participate in the plan by matching a part of your contributions, usually as a flat amount of, say, 25 cents for each $1 you contribute. An employer’s match isn’t taxable to you as current income, and the government allows earnings on this match to accumulate tax-deferred.
In a 401(k) plan, your employer selects a number of investment vehicles from which you can choose. The employer may use a single mutual fund “family” with a choice of five or six funds or multiple fund families with as many as 50 choices. The choice of funds can range from very conservative investments, such as guaranteed interest contracts, up to more speculative and risky aggressive growth funds. Some companies let you choose which stocks you invest in, and many companies offer company stock as a choice in the program.
At all times, you are 100 percent vested in the part of the contribution that is your own deferred money. That money belongs to you. You can take it with you when you leave that job, but you’ll need to transfer it to another retirement plan or rollover IRA. Otherwise, you’ll have to pay income taxes and penalties on the money, because that money was intended for your retirement.