401K

A 401K is a retirement plan sponsored by your employer. It is a defined contribution plan where you contribute a certain portion of your income into the account. 401K accounts are popular because of two main reasons.

As a retirement investment, the 401K has both advantages and disadvantages:
Pros:

Tax deferred until withdrawal. Possibility of additional contributions from employers

Cons:

Withdrawal penalties of 10% with certain exceptions. Lack of liquidity if the contributor needs the money for another purpose.

A further comparison of a 401K plan with other investments can be found here.

Benefits of a 401K

First they are a tax deferred plan, as an example let's say you put $4,000 dollars into the account over a year and earned $54,000 that year, only $50,000 would have to be claimed as income. On the other hand, the benefits upon withdrawal once you've retired are taxed as income. Second, employers may offer a matching contribution giving you a strong incentive to deposit into the 401K account because of the increase in assets gained if employers match the deposit.

The tax deferment option can be advantageous because retirees generally require fewer expenses than during their career so can live off of a smaller yearly income. This drives them to a lower tax bracket so they have to pay less on the withdrawals from their 401K than they would have paid during their working years.

Although a 401K is an employer provided benefit, if you were to change employers and your new employer has a 401K plan, you can transfer your old 401K plan to the new employer. If your new employer does not offer a 401K plan, it can be transferred to an IRA at another institution or the old employer may charge a fee to keep the 401K managed through them.

The money deposited in a 401K is distributed among a variety of assets that could include stocks, bonds, mutual funds, money market funds and others. The options available are based on the specific plan your employer allows and the proportion of funds in each can be regulated by the contributor manually.

Deposit Limits

401K contributions are limited to a maximum of $16,500 a year in 2009. People age 50 or older are allowed an exception to this limit in the form of catch-up contributions. These catch up contributions are limited to $5,500 in 2009. These limits are also imposed if more than one 401K (such as a traditional and Roth) are owned by the same person, there can be no more than $16,500 contributed to both accounts combined.

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