How to Make the Most of a 401(k)

Summing up the most important things you need to know about employer-sponsored retirement plans

From Standard & Poor's Financial Communications

As more Americans shoulder the responsibility of funding their own retirement, many rely increasingly on their 401(k) retirement plans to provide the means to meet their investment goals. That's because 401(k) plans offer a variety of attractive features that make investing for the future easy and potentially profitable.

Below we've listed a number of key points regarding 401(k) plans. Be sure to talk to your employer or plan administrator about the specific features and rules of your plan.

What Is a 401(k)?

A 401(k) plan is an employee-funded savings plan for retirement. It takes its name from the section of the Internal Revenue Code that created these plans, which are also known as "qualified defined contribution" retirement plans—"qualified" because they meet the tax law requirements for favorable tax treatment (described below) and "defined contribution" because contributions are defined under the terms of the plan, while benefits will vary depending on plan balances and investment returns.

Tax Treatment

The 401(k) plan allows you to contribute up to $15,500 of your salary in 2007 to a special account set up by your company. Future contribution limits will be adjusted for inflation. Keep in mind that individual plans may have lower limits on the amount you can contribute. In addition, individuals age 50 and older who participate in a 401(k) plan can take advantage of "catch-up" contributions of an additional $5,000 in 2007.

Commencing in 2006, 401(k) plans now come in two varieties: traditional and new Roth-style plans. A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.

The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit. However, plan balances grow tax-free; you pay no taxes on qualified distributions.

Both traditional and Roth plans require that distributions be qualified. In general, this means they must be taken after age 59½ (or age 55 if you are separating from the employer whose plan will be making the distributions), although there are certain exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% IRS penalty will apply in addition to ordinary income taxes on all pretax contributions and earnings.