How 401 k Plans Work

What makes a 401(k) different?


Four things differentiate a 401(k) plan from other retirement plans.

  1. When you participate in a 401(k) plan, you tell your employer how much money you want to go into the account. You can usually put up to 15 percent of your salary into the account each month, but the employer has the right to limit that amount. It might be worth your while to rally for a higher limit if it isn't as high as you would like it to be. The IRS limits your total annual contribution to $15,000 (for 2006).
  2. The money you contribute comes out of your check before taxes are calculated, and more importantly, before you ever have a chance to get your hands on it. That makes the 401(k) one of the most painless ways to save for retirement.
  3. If you're lucky, your employer will match a portion of your contribution. Your employer wants you to participate in the plan because of compliance issues we'll talk about later. The matched amount they offer (the free money part) is your incentive to participate.
  4. The money is given to a third party administrator who invests it in mutual funds, bonds, money market accounts, etc. They don't determine the mix of investments -- you do that. They usually have a list of investment vehicles you can choose from as well as some guidelines for the level of risk you are willing to take. We'll also talk about that later.

Here's what the overall process looks like:

The drawback to the 401(k)? If you withdraw your money before you are 59.5 years old, you'll have to pay the tax on it, PLUS a 10% penalty fine to the IRS.

How safe is your money?

What if your employer declares bankruptcy? How do you know your money is safe? The Employment Retirement Income Security Act (ERISA) that was passed in 1974 includes regulations that protect your retirement income. It requires that all 401(k) deposits be held in custodial accounts in order to keep your money safe in the event that something happens to your employer.

It also sets requirements that your employer must follow, such as sending you regular account statements, providing easy access to your account, and maintaining compliance so that the plan is fair for everyone in the company. It also requires your employer to provide you with educational materials about the investment opportunities within your plan.