How it works: A 401(k) plan is a long-term retirement savings account sponsored by an employer for its employees. It takes its name from subsection 401(k) of the Internal Revenue Code. This provision allows a company to help employees save for retirement while reducing their taxable income. Workers can choose to deposit a set percentage of earnings into a 401(k) account and not pay income tax until they withdraw the money in retirement.
Who's eligible: Employees who work at a company that offers a 401(k) plan can participate. Some companies may require you to reach a certain length of service before you can enroll.
Why? This is a painless way to save because the money is withdrawn directly from your paycheck and lowers your taxable income. The interest you earn on money in a 401(k) account is never taxed before the funds are withdrawn. Also, employers often match contributions that workers make, providing "free" money for retirement.
Why not? The 401(k) plan is typically administered by employers, and in some cases employers have weighted the plans too heavily in their own company's stock. If the company's stock plummets, value in the 401(k) plan plummets with it. However, in a participant-directed plan, employees can choose from different investment options.
Playing catch-up: If you're behind in 401(k) contributions, people 50 and over can contribute an extra $5,500 a year. The standard contribution limit is $16,500, and that means people over 50 can contribute a total of $22,000 this year.
2012 changes: The contribution limit for 401(k) plans increased to $17,000 for 2012, up from $16,500 in 2011. Catch-up contribution limits for those age 50 and older remain at $5,500.
The fine print: If your employer matches your contributions, those matching funds may be subject to vesting rules that require you to reach a certain number of years of service before you can keep the matching funds. Also, you are required to begin taking minimum distributions from your 401(k) account by April 1 of the calendar year after turning age 70½ or April 1 of the calendar year after retiring, whichever is later.
Resources: Visit Brightscope.com, the industry's most comprehensive database of 401(k) performance, to check out your company's plan. The site assigns a simple numerical rating to 35,000 plans, based on audit reports that all plans file with the U.S. Department of Labor, as well as other data sources. The scores are available to investors for free.
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