Wikipedia's explanation of 401(k) plans is a good place to get an overview of what exactly they are.
Who can have a 401(k) plan
401(k) plans are provided by employers to employees. You cannot set up a 401(k) plan for yourself (unless you are self-employed).
Benefits of 401(k) plans
401(k) plans are one of the most effective ways you can save for retirement. Some of the benefits they provide are:
- Employer matching
- High contribution limits
- Immediate tax savings
- Tax-deferred growth
Employer matching refers to the practice of your employer matching a certain percentage of your contribution -- giving an instant boost to your savings. One of the most common matching plans today is the 6%/3% plan (for lack of a better name). In it, employers match 50% of the employee contribution, up to 6% of the employee's salary (giving a match of 3%).
For example, if Jon earns $50,000 per year, and decides to contribute $100 per month to his 401(k), then the company will automatically kick in an extra $50 per month. If Jon contributes $200, the company will add $100 automatically. Sounds pretty good!
Now let's look at the cap. 6% of $50,000 is $3,000, which if you split over 12 monthly contributions would be $250 per month. So the most Jon's employer will ever match is half of that, or $125 per month. If Jon contributes $250 per month, the employer will add $125, for a total contribution of $375. Now if Jon decides to increase his contribution to $300 per month, the company will still only add $125, for a total of $425.
If your employer offers a 401(k) plan with employer matching, it is almost certain that you should contribute enough to get the full benefit of the match. In the above example, simply putting your money into the account instantly gives you a 50% return.
High contribution limits
401(k) plans have one of the highest contribution limits of any retirement plan. For instance, in 2008 you can put $15,500 into a 401(k) plan. However, you can only put $5000 ($6000 if 50 in 2008) into a Traditional IRA or Roth IRA. That means more immediate tax savings and possibly a more comfortable retirement.
If you don't have access to a 401(k) plan, you have several alternatives. See the list of retirement accounts for a full list.
- This article is based on an article from Finwikian, available under the GFDL, content later converted into CC-BY-SA.