In a 401(k) plan, you designate a certain amount of money from each paycheck to invest in stocks, bonds and money market funds. Your money is transferred to your account before you pay taxes, and the returns on your investments accumulate in your account. An administrator overseeing your 401(k) periodically updates you about the account's performance. After you reach six months past the age of 59, you can begin taking money out of the account, presumably to pay for your life after retirement.
There are several advantages to opening a 401(k). Because all of your contributions are deducted from your paycheck before taxes, you receive an immediate tax break. The money in your 401(k) account grows tax-free until you begin to withdraw it. 401(k) plans are shielded from creditors during lawsuits and bankruptcy filings, which isn't always the case with other retirement plans. And employers typically match 401(k) contributions to a certain dollar amount -- many have compared this to a salary bump just for planning for retirement.
There are drawbacks to 401(k) plans, as well. You are limited to the investments offered by your employer. Once you begin withdrawing from your 401(k), your withdrawals are taxed as income. If you withdraw before six months after you turn 59, you must pay taxes on the income, as well as a federal early withdrawal penalty of 10 percent and possible state penalties.
With the basics behind you, what should you do to get started on a 401(k) plan?