What, exactly, is a 401(k)?

When you start a new job, a lot of paperwork comes your way. It's easy to get overwhelmed and tune out. But if you hear something about a "401(k) plan," you might want to sit up and take notice.

401(k)s are named after a provision of the IRS legal code, and are retirement savings accounts that many companies use instead of a traditional pension plan. Typically, 401(k)s allow you to allocate a portion of your pre-tax income, and invest it in an account, where the savings can grow, tax-deferred. Once you reach age 59.5, you can begin withdrawing the money, and pay ordinary income tax on it.

Lower taxes, high interest

One benefit of a 401(k) is that, by delaying paying taxes on your earnings, you may reduce the amount of taxes you'll pay. After all, you'll probably be retired when you withdraw from your 401(k) account, which means that you'll likely be making less money. Less income translates to a lower tax rate.

For that matter, by delaying your taxes, you're essentially borrowing the money from the government, interest free. In fact, because the money's invested, you're getting paid interest.

A Roth 401(k)—another form of the plan—allows employees to contribute money after they've paid income tax on it. While you don't get the benefit of delayed tax payments, you also won't have to worry about taxes when you start making withdrawals.

The employer match

401(k)s can also give you free money. Many employers match some portion of their workers' contributions—and the more you deposit, the more your employer will match. "At an absolute minimum, the 401(k) participant should put in the full amount that will be matched to enjoy the maximum amount of free money from the employer," says Irvin G. Schorsch, founder of Pennsylvania Capital Management.

You may not even have to do anything to get the free money. Because employees sometimes need to be nudged to save for their retirement, many employers automatically sign their workers up for a 401(k). Some companies even offer an "escalation feature," which slowly increases the percentage of your salary that you save. For example, you might start by saving three percent of your salary but then get bumped up to four percent after working for several years.

Picking your investments

Most 401(k)s let participants choose from a mix of investment options. Some plans include target date funds, which invest in a variety of securities optimized for your retirement date. Or, you can choose to go the do-it-yourself route, with asset allocation funds that allow you to opt for a particular mix of stocks and bonds based on your own personal tolerance for risk and the number of years before you plan to retire.

Unlike pensions, which are usually connected to a particular company or union, 401(k)s are designed to move from job to job with you. When you switch jobs, you have 60 days to "roll over" your funds from your old employer's to your new employer's 401(k), or to an individual retirement account.

For all its many unique benefits, one of the best features of a 401(k) is also one of the most common: compounding. Because it's difficult to withdraw from a 401(k), most users simply let the money sit in investments, slowly growing and compounding. And those savings add up. "By starting early, even in small dollar quantities, the 401(k) participant gets to enjoy the magic of compounding," says Schorsch. "It creates significantly more wealth, particularly when it's combined with employer matching."

The bottom line is, a 401(k) can help you make the most of your money. But, of course, talk with your financial advisor for details.

Investing involves market risk, including possible loss of principal, and there is no guarantee that investment objectives will be achieved.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be a recommendation for any specific investment product, strategy, plan feature or other purposes. Any examples used in this material are generic, hypothetical and for illustration purposes only. Prior to making any investment or financial decisions, you should seek individualized advice from your personal financial, legal, tax and other professional advisors that take into account all of the particular facts and circumstances of your own situation. Outlooks and past performance are not guarantees of future results.

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