by Marcy Kennedy

Created on: January 15, 2009

HOW DOES A 401(K) PLAN WORK?

A 401(k) plan is a retirement plan that must be sponsored by a company or employer. Your employer takes a portion of your paycheck before taxes and invests it into an account where it will earn interest. You won't be taxed on this money until you withdraw it.

CONTRIBUTIONS

In 2008, the maximum amount that you could contribute to your 401(k) in one calendar year was $15,500 (pre-tax) if you were under 50 years of age and $20,500 (pre-tax) if you were between 50 and 65 years of age. Those 50 years old and older are allowed an extra $5000 per year as "catch-up contributions" in preparation for their impending retirement.

As an incentive, some employers will match a certain amount of their employees' 401(k) contributions. For example, if your company offers a 25% match and you contribute $10,000 to your 401(k), your employer will contribute an extra $2500. Contributions by your employer are subject to what's known as "vesting."

Vesting is a feature that companies use to reduce employee turnover. It refers to the amount of time you need to work for your company before you keep the full amount of their contribution to your 401(k) upon termination of employment for whatever reason. Your personal contributions to your 401(k) are automatically 100 percent vested. The vesting of your company's contributions accrues over time.

The Employee Retirement Income Security Act (ERISA) has set two different vesting schedules to be used as a minimum guideline.

ERISA 401(k) Vesting Schedule 1

Less than 3 years of work = 0 % of accrued benefits vested
More than 3 to Less than 4 = 20 %
More than 4 to Less than 5 = 40 %
More than 5 to Less than 6 = 50 %
More than 6 to Less than 7 = 80 %
At Least 7 = 100 %

ERISA 401(k) Vesting Schedule 2

Less than 3 Years of Work = 0 % of accrued benefits vested
Minimum of 5 Years of Work = 100 %

To find out which schedule your company uses, read your 401(k) plan summary or contact the human resources department.

WITHDRAWALS

Because your 401(k) is a retirement plan, you can only access this money under certain circumstances once it is invested:

(A) You officially retire at age 55 or older. You will pay tax on this money, but you will not have to pay any early withdrawal penalties.

(B) You apply for and receive a 401(k) loan. You must pay this money back to your 401(k) within a specified period of time, with interest, or you will be charged the taxes and fees that go along with early withdrawal. (For more information on this option, visit http://www.helium.com/items/1298145-borrowing-from-a -401k-plan

(C)

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