by Jack Thornton

Created on: January 21, 2009

With the decline in defined-benefit plans (pension plans) in this country, there was a need for an alternate way for people to fund their own retirement. This alternative is the 401(k), and it has been enough of a success that pensions are becoming less and less common.

ORIGIN

A 401(k) plan is named after the portion of the tax code that created them in 1981. There have been recent changes to add more options to the 401(k) choices, but at their heart these plans offer a way for an employee to set aside a portion of their income to invest for retirement. Often, companies match a portion of the employee's contributions, helping the retirement plan grow faster.

401(k) MANAGEMENT

When a company creates a 401(k) plan, they choose a trustee to manage the plan for them. This trustee is paid a fee for their work managing enrollment, payroll deductions, and handling investing choices made by the participants. This trustee also separates the company from the 401(k) plan. This is important. This separation means that employees lose nothing from their 401(k) accounts if the company goes bankrupt.

EMPLOYEE CONTRIBUTIONS

In a traditional 401(k), an employee's contributions are not taxable until they are withdrawn in retirement. So, by contributing to a 401(k), an employee will have to pay less in taxes now. This has a side benefit of reducing take-home pay by less than what is saved.

As a benefit - and an encouragement to save for retirement - companies match some contributions. Often, it is something like 50% on the first 6% of an employees salary. In this example, the employee can make an immediate 50% on their money if they contribute the full 6% of their salary to their 401(k).

Salary $100,000

Employee Contribution $6,000

Company Match $3,000

Total Contribution $9,000 plus a reduction in taxable income by $6,000

There are limits to how much an employee can contribute to a 401(k). For 2009, the limit is $16,500 pre-tax. Post-tax contributions can be made as well. Including employer and post-tax contributions, the limit is $49,000 per year. Employees 50 years old and over can make an addition $5,500 'catch-up' contribution.

MANAGING INVESTMENTS

A 401(k) is a self-directed retirement plan. Each plan offers a mix of different mutual funds and other investments to choose from. Plan participants can split their money between those choices however they would like. They cannot however invest in any options that are not already in the plan.

At any time, the participant can go in and reallocate

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