What is a 401k Plan? How does it work? What are the benefits of having a 401k retirement plan?

A 401k is a company/employer sponsored retirement plan that allows workers to take out a portion of money from their daily paycheques, store it on a retirement plan account and earn interest tax-deferred. Tax-deferred means this saved income is not taxable until you withdraw it at the age of 65 or more.

A 401k retirement plan must be sponsored by an employer or an organization. The actual work of administration and monitoring of accounts is usually outsourced to independent banks, mutual fund companies, financial service enterprises and more. As soon as an employee gets a paycheck at the end of the month, he can transfer a portion of it (there are annual limits) to his 401k account. Types of investments available include mutual funds, stocks, bonds, money market instruments (both short and long term).

How is money contributed to a 401k Retirement Account?

- Fixed percentage of paycheck goes directly into 401k account
- Employer makes profit-sharing contributions into the 401k plan
- Employer as an incentive, puts in extra money (on top of the paycheck deduction) into the employee's retirement account

If an employee quits working with his company, the 401k retirement account still remains active for the rest of his/her life.
Note: After 2004, some companies have started charging fees to administer and maintain your 401k retirement account if you have left their company.

If you leave your current employer and have a 401k account, you can move this account to a professional financial institution. After this, the account changes from a 401k retirement account into an IRA account. However, if an employee quits his former employer and joins a new one, he can do what's called a 401k rollover to his new company.

Details of 401k Retirement Plans

- In 2010, there is a limit of $16500 that an employee can put into his 401k account. This is a before-tax amount. For example, say you earn $50,000 a year. You can therefore allocate $16500 from this 50,000 and put it into the 401k account. What's your taxable income? $50,000 - $16500 = $33500

- Every year after you initially contribute an amount, you are allowed $500 more per year. This accounts for inflation.

- Employees who are over 50 years old are allowed what's called "catch-up contributions." On top of the original $16500, >50 years old employees can allocate an additional $5500 per year into their 401k accounts.

- This $5500 is also subject to an increase of $500 per year (to account for inflation).

- If you contribute more than the set limit ($16500), the excess amount must be withdrawn by April of the following year. If you do not do so, you will have to pay a certain penalty as well as taxes on the excess amount.