What's a 401(k)?

Welcome to the sixth and final installment of my personal finance education series What's a Blank?. Today I'll tackle one of the more advanced topics of financial planning, the mysterious 401(k) retirement plan.

The Origins

The name 401(k) references 26 U.S.C. § 401(k), a section of the Internal Revenue Code. A 401(k) plan is like a traditional IRA in that any money put into the plan will reduce your taxable income. Of course, you have to pay taxes on the money you pull out.

A 401(k) plan is primarily employer sponsored (meaning it's established by the company you work for). employees elect to have a portion of their wages paid directly into their individual 401(k) account, which is managed by the employer. Such payments are known as "contributions". As a benefit to the employee, the employer can optionally choose to "match" part or sometimes all of the employee's contribution by depositing additional amounts in the employee's 401(k) account or simply offering a profit-sharing contribution to the plan.

The Match

Matching contributions made by your employer are pretty much the coolest things ever. It's essentially free money, and it's incredibly foolish not to take advantage of it. In most cases, employers will only match a certain amount, so you'll need to check with your employer to find out how much is available (assuming a 401(k) plan is even available through your employer.

The Options

For the most part, you can invest in the same types of stuff you invest in with your IRA. That is, stocks, bonds, and mutual funds. The exact investment options offered by your employer will vary however.

Some people choose to invest all of their contributions in their company's stock. This generally isn't a good idea, unless your company is something huge that will never collapse (sorry former Enron employees).

The Drawbacks

Their are some consequences of early withdrawal, similar to those imposed on IRAs, but these consequences are imposed by your employer rather than the government (although you'll still have to pay excise taxes on whatever you take out). Employers can also restrict withdrawals except in certain situations. For the most part, you should avoid taking any money out of any retirement account because of the penalties involved.

The New Plan

Much like a Roth IRA, the newly introduced (in 2006) Roth 401(k) allows you to pay income tax now to avoid income tax on later withdrawals. This is generally an awesome idea, but not all employers offer the new plans. Like anything else I've mentioned, you'll have to check with your employer to see if a 401(k) is an option.

The Closing

All of the information I provide in my What's a Blank? series is obtained from a combination of Wikipedia and my own personal knowledge on the subject. Yes, all of this information is available here, but I'm pretty sure most people don't trawl Wikipedia for financial info (me being an exception).

If you're interested in opening a 401(k) plan through your employer (and you should be), then talk to the human resources department at your workplace. Happy investing!