Published September 24, 2012
Defined contribution plans are crucial for retirement planning. A good place to start: Join your company's 401(k) plan. Here's what you need to know.
How it works
401(k) plans are long-term savings vehicles that allow investors to defer income taxes until the money is withdrawn at retirement. Investors younger than 50 can contribute up to $17,000, or $22,500 for those over 50. Some employers provide a match to their 401(k) plans, which typically offer several mutual funds that workers can choose from. But they generally can't buy individual stocks or bonds.
Growth and withdrawals
Since the funds in 401(k) plans are usually invested in the market, they rise and fall like other investments. The average 401(k) grew, on average, 8.7 percent per year between 1999 and 2006, according to a 2007 study by the Employee Benefit Research Institute. But that was before the stock market collapse of 2008, which presaged a deep recession.
Despite the market's ups and downs, you can boost your retirement savings by simply leaving the money alone until you can start taking penalty-free distributionsat age 59 ½ or later. Withdrawing before then will involve a 10 percent penalty on top of income taxes, which are generally due regardless of your age. Investors can take out a penalty-free loan against their 401(k), but they'll have to pay it back with interest.
Getting funds out
The simplest way to avoid penalties is to hold off on withdrawals until you reach age 59 ½ or later. You must start taking pre-tax distributions by age 70 ½ unless you're still working and your plan permits you to delay taking distributions until you retire. Consult IRS Publication 590 to determine the distribution amount. Track your 401(k) progress with our 401(k) savings calculator.