How a 401k Plan Works

A 401k is a qualified retirement plan that allows eligible employees of a company to save and invest for their own retirement on a tax deferred basis. Only an employer is allowed to sponsor a 401k for their employees. You decide how much money you want deducted from your paycheck and deposited to the plan based on limits imposed by plan provisions and IRS rules. Your employer may, but is not required to, make contributions to the plan.

It is the employer's responsibility to operate the plan in accordance with law, rules and regulations, of the Internal Revenue Service, and Department of Labor, as well as the provisions of the plan itself. The employer is responsible for determining who is eligible to participate in the plan, how much and when they can contribute, how much the employer will contribute to the plan, what investment options you will have, how often you can reallocate your investment assets, hiring the vendors necessary to run the plan, and what features the plan will have (such as loans, hardship withdrawals, frequency of deferral and investment election changes, etc.).

It is your responsibility to decide if you want to participate in the 401k, and if so, how much you will contribute each pay period. If you earn $800 each pay period and elect to defer 10% of your pay, $80 is taken out of your pay and deposited into the 401k plan. These contributions are deducted from your salary on a pre-tax basis. This means that by contributing to a 401k, you actually lower the amount you pay in current income taxes. For example, instead of being taxed on the full $800 per pay period, you are only taxed on $720 ($800 minus your 401k contribution of $80 equals $720). You are responsible for paying social security tax on your deferrals.  You will not owe income taxes (federal and state) on the money contributed until you withdraw it from the plan.

Important things to remember about 401k plans:

Don't put off participating in your 401k, even if you think you can't afford to. Time is your best guarantee that you will make your retirement goals, so the sooner you start contributing the better off you are going to be in retirement. Even just one or two percent will make a big difference.

A 401k is a retirement plan, not a savings account. Money placed in a 401k is not easy to access in an emergency. Some plans allow loans and hardship withdrawals, but the rules governing them are restrictive.

The plan sponsor is required to provide you with a Summary Plan Description. It contains information about how your plan works, what options are available, who the trustees are, and other important information. You can request another copy if you misplace your copy.  You may also be able to access the Summary Plan Description, as well as other plan forms, on the third party administrator's web site (if your plan allows for on-line investment access).