How 401(k) Retirement Plan Works

When you join a 401(K) plan, you tell your employer how much money you want to contribute to your account. This amount is deducted from your salary before taxes are applied, so you pay less income tax. More importantly, the money is deducted even before you have received it, making it the easiest savings plan to contribute to. Your employer (usually) matches a portion of your contribution. The money is invested by the plan administrator (on your behalf) in mutual funds, bonds, money market accounts, etc. You decide the mix of investments. They usually have a list of investment vehicles you can choose from as well as some guidelines for the level of risk you are willing to take. Since the plan is an incentive for retirement savings, there is one condition: if you withdraw the money before you are 59.5 years old, you will have to pay tax as well as a 10% penalty fine to the IRS.

There are several reasons why investing in a 401(K) plan is advantageous to you:

• The money you contribute is free from Federal and State taxes.
• Your employer receives tax benefits for contributing to your 401(K) - this is extra money for you
• There is a range of investment options and an expert does the actual investing according to your directions.
• Any gains and earnings through this investment are also tax deferred.
• You can take loans and hardship withdrawals from your 401(K) under certain circumstances
• The money is deducted even before you receive your salary, thus making it easy to stick with regular saving and investing.

To invest in a 401(k) is entirely depends on your company's policy. Many companies require that new employees complete six months to a year of service before they are eligible to participate in the 401(K) plan. Speak to someone in the Human Resources Department of your company to find out how things work.

As to the amount of money to contribute you are usually allowed between 1-20% of your salary into the 401(K). The maximum pre-tax dollar amount is set by law and adjusted for inflation annually. It all depends on the restrictions of the 401(K) plan your company offers. For more information, contact your Human Resources Department.

With regard to withdrawal or borrowing money from your 401(K) you should remember that the plan was devised as an incentive for retirement savings. If you withdraw money from your 401(K) before the age of 59.5, you will be required to pay tax and a 10% penalty fine to the IRS. However, there are certain circumstances under which money can be taken from your account prior to retirement:

• Loans: Some 401(K) plans allow you to take a loan against the money you have contributed to the plan. Every company will have its own rules for the loan. Usually they require that there is an extreme hardship, such as health problems, financing a home or such other emergency. Check with your Human Resources Department for details.
• Hardship Distribution: Some plans allow for a withdrawal in extreme hardships - illness or great financial need. Not all plans do this and usually, if this option is used before the age of 59.5 years, a 10% penalty fine is assessed on the withdrawal. You might have to pay the applicable income tax and will most probably not be allowed to participate in the 401(K) plan for six months. Check with your Human Resources Department for details.
• Distribution upon termination of employment, death or disability: In case of termination of employment, you have the option to take a cash distribution of your funds from the 401(K). If you choose this option, 20% of the money may be held for income tax and the 10% penalty fine may be applicable if you are under 59.5 years of age at the time of withdrawal. In case of death or disability, you or your beneficiary can take the distribution. The 20% income tax may apply. If you wish to avoid this taxation, you must invest the money in a qualified retirement plan within 60 days.