Beginner's Guide to 401(k)'s

By Jonathan Bales , last updated June 28, 2011

Saving for retirement is an essential part of effective financial planning and understanding the basics of 401(k)'s will help you prepare for retirement. A 401(k) is a retirement plan in which a person contributes funds to a savings account and is able to remove them once he or she turns 59 1/2 years old. The 401(k) retirement plan became popular in the early 1980s for American workers, and it differed from previous retirement accounts in that the worker, not the employer, was responsible for making contributions. Employers will sometimes aid employees in contributing to a 401(k) because they can deduct the contributions from their taxes. The same is true for employees, although they have to pay a federal income tax on any withdrawals which are later made from their 401(k) account. Often times, employers will match the contributions of their employees. Employees do not need to pay tax on any interest gained until they make a withdrawal.

A 401(k) account is usually set up by an employer on behalf of the employee, with the latter able to choose from various investment options. The majority of 401(k) accounts have investments in stocks and bonds, but the employee usually gets to select the type of mutual funds in which he or she would prefer to invest. Employees can often choose to invest in their company's stock as well, and he or she can divide up the allocation of investments differently at any time. In rare cases, a company will allow its trustees to decide how the employees' 401(k) investments will be set up.
In 2006, a new type of 401(k) account emerged known as a Roth 401(k). Like a Roth IRA, a Roth 401(k) forces the employee to pay taxes on all contributions to the account. Some may prefer to pay for taxes up front, however, because all qualified withdrawals are tax-free. Thus, a traditional 401(k) and Roth 401(k) are synonymous to a traditional IRA and Roth IRA, respectively. Roth 401(k) accounts usually come in addition to the traditional variety, meaning no employee has only a Roth 401(k).
To withdraw money from a 401(k) account, a few criteria must be met. Most importantly, the person must be at least 59 1/2 years of age. Withdrawals prior to this age are permissible, but the owner of the account must pay a heavy tax. This is usually 10% on top of the regular income tax that must be paid on all traditional 401(k) withdrawals. There are a few ways around this rule, including death, disability, medical expenses and so on.
Most 401(k) accounts allow for loans to be taken from the account, as long as they are repaid with interest. This loan is not taxed and there is no penalty for withdrawing it. These loans generally have fairly high interest rates and must be repaid within five years. In the event that the owner of a 401(k) defaults on a loan payment, the rest of the loan balance then becomes taxable. Many people believe taking loans from a 401(k) is a poor decision because you get taxed twice during the process (for interest). While this is true, the fact that after-tax funds are used to pay for taxable interest makes a loan from a 401(k) no different than a traditional loan.
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