How 401 k Plans Work

401(k) vs. Stocks

Why would you be better off contributing to a 401(k) plan than you would be, say, investing in stocks on your own? After all, with your own investments at least you're not penalized when you sell them.

There are several advantages to a 401(k) over your own investments. Of course, that doesn't mean you shouldn't do both. It is always a smart move to diversify (or spread out) your overall financial investments. The primary advantages to a 401(k) are that the money is contributed before it is taxed and your employer may be matching your contribution with company money. There are other advantages, but let's talk about the two heavy hitters first.

What does "pre-tax" really mean?

Let's do the math to see the advantage of pre-tax saving. For example, you may decide you want to put $200 into your account each month. Assume that, prior to starting your 401(k), you were bringing home $2,000 per month pre-tax, and $1,440 post-tax (paying $560 in tax for a 28-percent tax bracket). Because the $200 comes out pre-tax, that means you are taxed on $1,800 (paying $504 in tax), so your post-tax income is $1,296. In other words, you are paying $200 into your 401(k), but your take-home pay only goes down by $144. You just saved $56 per month!

In addition to reducing the amount of tax you pay on your salary, you'll also defer tax on earnings from your 401(k)'s investments until retirement. At that point, you will probably be in a lower tax bracket anyway. You may also be living in a state that has no state income tax. (FYI, those states are: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Tennessee and New Hampshire only tax dividends and interest income.) It may not seem like a big deal now, but try out this Taxed and Non-taxed Compounding Calculator to see how much this can make a difference over the years.

Free money?

Let's talk about that free money from your employer. Although they aren't required to, many employers match a percentage of what their employees contribute to their 401(k) accounts. The catch is, they typically don't put anything in unless you do. (We'll talk about "Safe Harbor" options later -- these can require your employer to contribute to every eligible employee.) If you aren't participating in the program, you're basically leaving money lying around for someone else to pick up. It's like finding a $20 bill at the amusement park and leaving it lying on the ground.

Another thing to remember about the contributions your employer makes is that, although the total annual amount they can contribute is limited by the IRS, that amount doesn't count toward the total annual amount you can contribute ($15,000 in 2006).

There is an overall limit on how much can go into your 401(k) account each year. The total for 2006 is $44,000 or 100 percent of your annual salary, whichever is less. This limit is referred to as the 415 limit (also named after the Internal Revenue Code that established it).

A small downside to the employer contribution is that there may be a vesting schedule. Vesting means that there is usually a tiered schedule for when money the employer contributes to your account is actually yours. For example, your employer may have a three-year vesting schedule that increases your ownership of the money by one-third each year. After three years, the money is all yours and all future contributions are 100-percent yours.