Learn even more about this topic with the Encyclopedia of Personal Finance™
401(k) plan is a retirement savings and investment plan offered by
employers to their employees. Many employers like it because it costs less than
a traditional pension plan; many employees like it because it can be more
lucrative and gives them more control over their retirement income.
With a 401(k) plan, you can take a portion of the cash your
employer would have paid you in wages, and choose instead to contribute it to a
qualified tax-deferred retirement plan (in other words, one set up
according to IRS rules). You contribute the funds pre-tax, so you don't have
taxes withheld on the portion of your income you contribute.
As a benefit of employment, many employers will match your
contribution to your 401(k) plan, anywhere from 1 to 100 percent of your
Most plans allow you to invest in many different kinds of
instruments: different kinds of mutual funds for stocks and bonds, money market
funds, and guaranteed investment funds that pay a pre-set interest rate. You
determine what portion of your contribution goes to each fund, and many plans
let you transfer money among funds.
Unlike traditional pensions, 401(k) money is portable—you take it
with you even if you change jobs. But there are tax penalties for withdrawing
funds before retirement. Unless you have some kind of qualifying hardship, funds
you withdraw are taxed at regular income rates; plus, there is an additional tax
penalty of 10 percent.
Many plans do allow the option of borrowing from your funds
without taxation, as long as you pay the money back in a prescribed manner.
Employees of qualifying non-profit institutions may
have a variation of this plan, called a 403(b) plan. Nonprofit employees
who want to participate in a plan other than the one offered by their company
can set up a 403(b)-7 account with virtually any company offering mutual funds.
Now let's look at a similar plan that individuals can set
up for themselves: the IRA.