If your employer offers a 401(k) plan, you should take advantage of this benefit. A 401(k) is a tax-deferred retirement plan. Tax-deferred means you do not pay taxes until you take the money out for your retirement. With a 401(k), both you and your employer put money into your retirement account and get tax advantages.

401(k) plans are sometimes called “salary reduction plans.” This is because money is taken out of your paycheck before taxes are paid on it, so you do take home a reduced salary, but the long-term benefits are great.

Here's how it works: Usually the 401(k) deduction is taken out of every paycheck. You decide how much to contribute and your employer may choose to match 3% or more of that amount. If your employer matches a portion of your 401(k) contributions, you should contribute enough to take full advantage of this benefit. After all, this is money given to you in addition to your salary.

With a 401(k), you don’t pay federal or state income taxes on the money you put into the 401(k) until you retire. Let’s say you make $50,000 a year, and you and your wife are in a 28% tax bracket. For every $1,000 you earn, the government takes $280. Looked at another way, when you invest on your own, you first have to pay that 28% tax. This means that every $720 you invest on your own is the same as $1,000 in your 401(k).

Some 401(k) plans offer investment choices for you to decide to place money in a money market account, bond or stock mutual funds. As your 401(k) fund makes profits, those new profits are added into your fund.

You get the benefits of compound interest (see “Very Interest-ing” article link below) and you don’t pay taxes on it. Alternately, when the investments you make on your own make a profit, you have to pay income tax on them.

The money you put into your 401(k) does not count against your annual income tax. For example, let’s say you make $50,000 a year and put $5,000 in your 401(k). This means your annual income for federal and state tax purposes is only $45,000. However, you still have to pay Social Security, Medicare and federal unemployment taxes on your 401(k) contribution.

As you might guess, the government limits the amount of money you and your company can put in your 401(k) each year. This amount changes every year. People over 50 years may be eligible to put more into their funds.

It used to be that only big companies offered 401(k) plans, because smaller employers couldn't afford them. More and more companies offer 401(k) plans now, and they often take care of all the details for their workers. They hire an investment company to manage the 401(k) funds, keep records, and inform people how their investments are doing.

Generally the employee does not own 100% of the contribution immediately; instead,the employee has to be at a job for a certain length of time in order to “vest” or acquire ownership of portions according to a vesting schedule. There may be a vesting schedule with rules like after three years with your company, you own 20% of your fund; after six years, you own 80%, etc.

With cliff vesting, the company owns your entire fund until a certain length of time, usually seven years.

If you change jobs, you can take your 401(k) with you. At your new job, your new employer can contribute to your old 401(k). If you go somewhere without a 401(k) plan or become self-employed, your fund can be converted to an IRA.

Keep a long-term outlook on your 401(k) money, and try not to touch these funds until retirement. If you need money for a financial emergency like medical expenses or college tuition, you can take money out of your 401(k). This is a hardship withdrawal. You have to prove your hardship, and you have to pay income taxes plus a 10% penalty on the amount you withdraw.

You can also borrow money from your 401(k) and pay it back at market rate interests. There are often rules like you cannot borrow more than half your fund and you must pay it back within five years.

You can withdraw money from your 401(k) when you are 55 years old if you have quit your job or become disabled, and at 59-1/2 years even if you are still working.

If you withdraw money before 55 years if you have quit your job or become disabled or before age 59-1/2 when you are still employed, you have to pay a 10% penalty tax plus the other taxes owed on it.

Some companies make you take all the money out at once as a lump sum and pay taxes on the whole fund the year you take it out. The income tax you owe will be at least 20% of your fund.

Some people avoid taxes on their 401(k) withdrawals at retirement by putting their 401(k) money into another tax-deferred account like an IRA. Some companies let you open up an annuity plan. You pay taxes on the amount you withdraw from your account (so you pay taxes little by little instead of being hit with one big bill). You must take the money out of your 401(k) by age 70-1/2 years.

401(k) plans are very popular. Some 20 million Americans now have over $2 trillion invested in them. If you're one of millions who are eligible but do not participate in a 401(k) plan, ask your Human Resources department to help you get started right away.

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