Traditional pension plans are known as a “defined benefit plan”, while 401(k)’s are called “defined
contribution plans”.
So just exactly what is a 401(k), how does it work, and why should I take advantage of one? And
when and how do I get my money back out of it?
A 401(k) plan allows employees to contribute a portion of their paycheck with pre-tax dollars to a
retirement fund. The employee selects how the money is to be invested among the choices offered by
the company, such as mutual funds, money market accounts, and other investments such as the
company’s stock.
Probably the greatest advantage of many 401(k) plans is the employer’s matching all or part of your
contribution. This is free money that will grow tax-deferred. Employers vary on how much they contribute.
Under a traditional pension plan, workers are pays paid a fixed rate after retirement, usually
based on their number of years of service and salary. The employer decides how the money is
invested. When an employee changes jobs, the pension benefits may be lost if the employee has not
worked enough years to become “vested”.
With a 401(k) plan, you always keep all of the money that you have contributed, along with its
earnings. In order to keep the money that your employer has kicked in, you are generally required
to work for that company a specified number of years, generally from two to seven, to become
vested. Even if you work a lesser amount of time, you are usually allowed to keep part of the free money.
The tax advantage of a 401(k) plan is significant. Not only is your contribution tax-deferred, but
your adjusted gross income is reduced by the amount that you put into the plan, This means that you
also pay less income tax on the remainder of your paycheck. You win in two ways.
Since deductions are made automatically from your paycheck (you decide how much), you don’t have an
opportunity to find excuses to spend the money instead of saving it.
Currently you can contribute up to $12,000 each year (combined with any contribution from your
employer), and increasing to $15,000 in 2006. If you are over 49, you are allowed to contribute an
extra $1,000.
The law requires that you begin withdrawing money from your 401(k) plan by the age of 70 ½. You may
begin withdrawals at 59½ without any early withdrawal penalty. You are also exempt from this
penalty if you are over 55 and have been let go by your company, or if you become totally disabled.
About 85% of 401(k) plans allow employees to take loans against the money in their account, up to a
maximum of 50% of their savings. The money you borrow is not subject to the 10% penalty as long as
you pay it back (with interest) within the time established by your employer’s plan.
Other Retirement Planning Topics:
-
Retirement Planning
- IRA’s (Individual Retirement Account) – Traditional IRA
- Roth IRA – Taking Money Out
- Employer Sponsored Retirement Plans
- Retirement Plans - Continued
- 401K Savings
- Notes for 403(b) Plan Participants
- Senior citizens retirement resources
- Retirement Plans for Small Business and Sole Proprietors
- Simplified Employee Pension (SEP) IRAs
- SIMPLE (Savings Incentive Match Plan for Employees) IRA
- Your own 401(k) for the self-employed
- Employer Retirement Plan Vesting and Contribution
- Forgotten Retirement Benefits
- Other thoughts about retirement accounts
- Other thoughts about your retirement needs
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