Introduction to 401(k) plans

In the old days,
workers had to depend upon personal savings and company pensions to fund their
retirement. Saving money is a good thing, but savings accounts don’t pay much
interest, and there isn’t a powerful motivation to save large amounts of money
when it doesn’t produce much growth. Plus, if you were saving for retirement
you still had to pay income tax on the money put into savings. If your savings
account earned interest you had to pay another tax on the interest income.

To encourage people
to save for retirement, in 1978 Congress amended the Internal Revenue Code,
later called section 401(k), so that employees are not taxed on income they
place as deferred compensation into a special retirement account. Under the
amendment employees may elect to have a portion of their wages paid directly,
or “deferred,” into a 401(k) account. 401(k) plans allow workers to
save for retirement while deferring until withdrawal federal income tax on the
saved money and earnings.

While the 401(k) is
similar in nature to an IRA, there are significant differences. An IRA can’t
accept matching company contributions, and personal IRA contributions are
subject to much lower limits.

The 401(k) law went
into effect on January 1, 1980. By 1983 almost half of large firms in the
United States were offering a 401(k) plan. By 2005 there were
approximately 50 million active participants in 401(k) plans.

Aside from tax
benefits, the most attractive feature of 401(k) plans is that your employer
will often match a percentage of your contribution, often as much as 50 cents
per dollar, and up to six percent of your salary. This is essentially free
money for the employee. In addition, your 401(k) is protected by pension
(ERISA) laws. This includes protection of the funds from garnishment or
attachment by creditors, or from court-ordered assignment to another individual
except in the case of divorce decree or child support orders.

You should contribute
as much as you can, especially if your employer makes a significant match. If
you can’t contribute the maximum, try for at least 10% of your annual salary.
Or begin with a percentage of pay you can live with and increase that rate by
one percentage point annually. Make every effort to take full advantage of your
employer’s matching contribution, because any money you don’t match is money thrown
away.

There are
restrictions. Since the 401(k) is a retirement plan, you should leave the money
in the plan until you reach the age of 59 1/2. If you make a withdrawal before
that date, you will generally pay taxes plus a 10% penalty. There are certain
conditions that allow for taking money out early, such as a disability or
first-time home buying. Some plans will allow you to borrow some portion of the
money in your plan, but you usually have to pay it back with interest. You
should read the fine print of your plan carefully, as the details will vary
from plan to plan.

You must begin to
withdraw funds from your 401(k) at age 70 1/2.

There are also fees
involved. Fees associated with running 401(k) plans can be 1.5% or more. Small
company plans may be higher. Your human resources department will be able to
tell you what fees you’re paying.

The bottom line is
this: if your employer offers a 401(k) plan, check it out. Take advantage of
what is essentially free money for your retirement.