401(k) Accounts: The Basics


How it works: A 401(k) plan is a long-term retirement savings account sponsored by an employer for its employees. It takes its name from subsection 401(k) of the Internal Revenue Code. This provision allows a company to help employees save for retirement while reducing their taxable income. Workers can choose to deposit a set percentage of earnings into a 401(k) account and not pay income tax until they withdraw the money in retirement.

Who's eligible: Employees who work at a company that offers a 401(k) plan can participate. Some companies may require you to reach a certain length of service before you can enroll.

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Why? This is a painless way to save because the money is withdrawn directly from your paycheck and lowers your taxable income. The interest you earn on money in a 401(k) account is never taxed before the funds are withdrawn. Also, employers often match contributions that workers make, providing "free" money for retirement.

Why not? The 401(k) plan is typically administered by employers, and in some cases employers have weighted the plans too heavily in their own company's stock. If the company's stock plummets, value in the 401(k) plan plummets with it. However, in a participant-directed plan, employees can choose from different investment options.

Playing catch-up: If you're behind in 401(k) contributions, people 50 and over can contribute an extra $5,500 a year. The standard contribution limit is $16,500, and that means people over 50 can contribute a total of $22,000 this year.

2011 changes: The 401(k) contribution limits remain unchanged from 2010. The 2011 contribution limit is $16,500 for workers under 50, and $22,000 for those 50 and above.

The fine print: If your employer matches your contributions, those matching funds may be subject to vesting rules that require you to reach a certain number of years of service before you can keep the matching funds. Also, you are required to begin taking minimum distributions from your 401(k) account by April 1 of the calendar year after turning age 70½ or April 1 of the calendar year after retiring, whichever is later.

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