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Probably everybody have heard that there is something called 401(k), but a lot of you don’t know what it is. Well, 401(k) is a voluntary retirement investment plan, and in simple words that is money you save for retirement.

There are two types of 401 plans. There is a 401(k) and also a 401(k) SIMPLE (Savings Incentive Match Plan for Employees). What makes them different is their allowances:

The SIMPLE plan is generally for companies that have 100 or less employees. Employees with SIMPLE can contribute maximum of $10000 per calendar year, or 12000 for individuals of age 50 and up. Employers are also required to contribute 2 to 3% employee contributions if SIMPLE 401(k) is offered.

Regular 401(k) plans (for companies with 100+ employees) allow workers to contribute up to $15500 per year, or 20500 for employees of age 50 and older. Employer matching is not required but most companies do match certain percentage.

How does a 401(k) plan work? In short, employees contribute money, those funds are invested and released at retirement. Since it is a voluntary plan, employees are the ones to choose how much to contribute. All withholding are done on a pretax basis, therefore the more money are withheld, less taxes will be paid. The minimum contribution is 1% of the pay (either weekly, bi-weekly or monthly), up to the maximum allowance, mentioned earlier. Money, saved in a 401(k) plan can be withdrawn at age of 59 and a half. When withdrawn, income taxes become due. If funds are withdrawn before that, a 10% penalty has to be paid, except for certain loan situations. Money can also be withdrawn without penalty for 4 reasons: death, disability or termination of employment.

Many employers offer what’s called matching. It is a percentage of what you are contributing. So let’s say that your employer matches 7% of your contributions. That means for every dollar you save, your employer will match 7$, thus giving you 7 cents per buck. Its free money! And even if you think that this is not much, here is a simple example: let’s say that you are contributing $500 per month and your employer matches 8%. After 30 years of working you will have saved $180,000. Your employer will give you another $14,400 for free. Not bad, right?

After you have contributed money, your funds are invested in various stocks. Your employer partners with a 401(k) company such as Merrill Lynch, for example (also called a plan administrator). You are usually given the option to choose which markets you want to invest in, or you can leave it on autopilot and let the company handle it for you. Employers have the right to decide how long you have to work for them before you become fully entitled (vested in) to the employer contributions. Your contributions are always 100% vested.

There is a “hidden” drawback in the employer matching system. They will match, for instance, 8% for your dollar, but very often to a certain amount. For example, company K matches 8% up to 3000 per year. Which means that they will match until your contributions reach $3000 and that’s it (for the year). It is a good idea to ask what that amount is before contributing large amounts, because you may end up not receiving what you have expected.

To summarize everything above, 401(k) is a good way to save money for retirement. With a good employer matching, it earns good free money, and if the market turns out well, you are also like to get good profit sharing from your retirement investment. My advice: max out your employer’s 401(k) match. You won’t even miss those money - hey will be safely put away before you get a chance to spend them.

Tags: 401(k) | retirement | investing | savings | matching | contribution | incentive