A 401(k) is a type of employer sponsored qualified defined contribution retirement plan that allows employees to save and invest for their own retirement. Through a 401(k), you can authorize your employer to deduct a certain amount of money from your paycheck before taxes are calculated, and to invest it in the 401(k) plan. Your company's plan offers different investment options - you choose the ones in which you want to invest your money. The plan gets its name from the section of the Internal Revenue Code which established them (Section 401(k)).
You decide how much money you want deducted from your paycheck and invested during each pay period, up to the maximum annual dollar limit each year and any plan limit. You also decide how to invest that money, choosing from your plan's different investment options. The money you contribute to your 401(k) account is deducted from your pay before income taxes are taken out. This means that by contributing to a 401(k), you can actually lower the amount you pay each pay period in current taxes. For example, if you earn $1,000 each paycheck, and you contribute, say 5% ($50), you are only taxed on $950. You don't owe income taxes on the money until you withdraw it from the plan, when you could be in a lower tax bracket.
What's the difference between investing my money through my company's 401(k) plan and investing my money into a mutual fund or saving through a bank account on my own?
Taxes, taxes, taxes! An ordinary savings account or mutual fund doesn't allow you to save on a pre-tax or tax-deferred basis. So in an ordinary savings account, you're saving money that has already been taxed, and you continue to pay tax annually on the earnings of that account, too. The money you contribute to your company's 401(k) retirement plan, however, comes out of your paycheck before taxes are taken out. Plus, you don't pay income tax on the money you contribute to your 401(k) account or on any earnings until you take it out. This is usually at retirement, when you may be in a lower tax bracket. The bottom line: More of your money is working for you instead of going toward taxes. Keep in mind, however, that investing in your company's 401(k) plan is only a part of sound retirement planning. It is still important to have personal savings in addition to your retirement plan savings. Make sure to talk to your financial advisor about comprehensive retirement planning.
What's the difference between a 401(k) plan and my company's profit sharing plan?
A profit sharing plan is a type of employer sponsored qualified defined contribution retirement plan. It allows an employer to contribute to the plan. The amount of the contribution can change each year, or may not be made at all, subject to the plan sponsor's discretion.
The 401(k) component is a feature of a profit sharing plan . Employees can contribute a percentage of their own salaries (up to certain limits, before taxes) to the plan for retirement savings. 401(k)s also allow employers to contribute money to its employees' accounts in the form of company match contributions, often as an incentive to get employees to participate in the plan. Current income taxes are deferred on both employer and employee contributions and any investment earnings, until the money is withdrawn from the plan.
The maximum amount that you can contribute to a 401(k) is limited to $14,000 for 2005 and $15,000 for 2006. (This is the annual IRS dollar limit, which can change each year, depending on cost of living increases.) If you are age 50 or older you may also be eligible to make catch-up contributions of an additional $4,000 in 2005 and $5,000 in 2006 if the plan allows.
What if my company goes bankrupt? How is my 401(k) money protected?
The Employee Retirement Income Security Act of 1974 (ERISA) was enacted to protect the interests of participants in employee benefit plans (such as 401(k)s) and their benefits. The upshot of it is that under ERISA and the Internal Revenue Code, your 401(k) plan account is not considered an asset of your employer - it is held in trust in a separate account for you. This means that your plan money (which includes all your own contributions and all vested company contributions) is not commingled with your company's money. And, your employer cannot access your plan money for any purpose related to maintaining its business.
*Assets in your retirement savings plan are not insured by the FDIC or guaranteed by the US government.