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How Does a 401k Plan Work


A 401k is a qualified retirement plan that allows eligible employees of a company to save and invest for their own retirement on a tax deferred basis. Only an employer is allowed to sponsor a 401k for their employees. You decide how much money you want deducted from your paycheck and deposited to the plan based on limits imposed by plan provisions and IRS rules. Your employer may also choose to make contributions to the plan, but this is optional.

It is the employers (also called the plan sponsor) responsibility to run the plan in accordance with law, rules and regulations, and provisions of the plan itself. This includes deciding who is eligible for the plan, how much and when they can contribute, how much the employer will contribute to the plan, what investment options you will have, how often you can reallocate your investment assets, hiring the vendors necessary to run the plan, and what features the plan will have (will loans be allowed, will hardship withdrawals be allowed, etc.).

It is your responsibility to decide if you want to participate in the 401k, and if so, how much you will contribute each pay period. If you earn $750 each pay period and elect to defer 5% of your pay, $37.50 is taken out of your pay and placed in the 401k plan. These contributions are deducted from your salary on a pre-tax basis. This means that by contributing to a 401k, you actually lower the amount you pay in current income taxes. For example, instead of being taxed on the full $750 per pay period, you are only taxed on $712.50 ($750 minus your 401k contribution of $37.50 equals $712.50). You don't owe income taxes on the money contributed until you withdraw it from the plan.

Here are a couple of things to remember about 401k plans.

Don't put off participating in your 401k, even if you think you can't afford to. Time is your best guarantee that you will make your retirement goals, so the sooner you start contributing the better off you are going to be in retirement. Even just one or two percent will make a big difference.

A 401k is a retirement plan, not a savings account. Money placed in a 401k is not easy to access in an emergency. Some plans allow loans and hardship withdrawals, but the rules governing them are restrictive.

The plan sponsor is required to provide you with a Summary Plan Description. Read it! It contains lots of good information on how your plan works, what options are available, who the trustees are, and other important information. You can always ask for another one if you misplace your copy.

You are the only person who has your own vested interest fully at heart, so it is up to you to ensure you know what your plan is all about and how to take full advantage of it. The only way to do this is to educate yourself. Go to all educational opportunities that your employer offers. Read all the material your employer provides on the plan. Surf the web and find a couple of good sites on 401k plans like 401khelpcenter.com. Understand your investment options. Ask questions.

Here are some additional resources:

What Is a 401k plan? A Quick Overview

How Employers Choose Funds to Offer in Their 401k Plans

Waiting to Become Eligible

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