What the Fool Is a 401(k)?

What is a 401(k)? With a name only the IRS could love -- based on the section in the tax code that gave it life -- the 401(k) is a financial plan that lets employees contribute money toward their own retirements. It was created in 1980 to shift more of the responsibility for retirement savings away from employer-based pension plans.

How does a 401(k) work? Employers set up individual accounts for each employee who enrolls in their 401(k) program. Employees can contribute a pre-tax chunk of each paycheck to their 401(k), reducing their taxable income. Chip in $5,000 a year of a $40,000 salary, and the IRS will only make you pay taxes on the remaining $35,000. Better yet, money in your 401(k) account is completely shielded from the tax man's clutches. Dividends, stock sales within the account, and other events that would ding you for taxes in a regular brokerage account are beyond the IRS's reach in a 401(k). You're only taxed on the money when you withdraw it in retirement.

All this and free money, too? In some cases, yes. To encourage employees to participate in the plan, some employers provide matching funds; for example, $0.50 for every dollar the employee contributes, up to a certain percentage of that employee's salary. For employers, this is way cheaper than footing the entire bill for employee pension funds, and they get a sweet tax break to boot. For employees, this is -- we can't emphasize this enough -- free money. A $0.50-per-dollar match is like an instant 50% return.

What kind of investments can I put in a 401(k)? That depends on your employer's plan. Most plans offer a limited menu of stock and bond mutual funds. Some also allow you to buy individual stocks with the money you contribute, though additional commission fees may apply.

What's the catch? Alas, the stock and bond funds in your employer's plan might be lousy options -- overpriced and underperforming. Look for options with low expense ratios -- 1% is the market's average, so shoot for less -- and market-beating performance over the past 10 years or since the fund began.

If all else fails, consider funneling your 401(k) contributions into a broad-market index fund, which will likely have a low expense ratio, yet still outperform most actively managed mutual funds. (Sad but true!) And if even the index funds are too rich for your blood, start bugging your human resources department to change plans and give you better options.

Even if you've got great investment options for your 401(k), there are limits on how much you can contribute each year. For 2010, the ceiling is $16,500 for people 49 and younger, or $22,000 for folks 50 and older.

Also, like an IRA, you'll typically have to wait until you reach age 59 1/2 before you start withdrawing money from your 401(k). In most cases, if you try to withdraw money earlier than that, you'll be slapped with taxes and an extra 10% penalty. There are a few exceptions, but they're complicated and tricky. Take our advice: Just leave your 401(k) alone until you're ready to retire.

What if I change jobs? You can avoid a tax hit by converting your old 401(k) into a rollover IRA, or get your new employer to roll over your old account directly into your shiny new 401(k). Make sure that when you do, the money gets transferred straight from one large, faceless financial organization to the other, rather than getting a check for the balance made out to you. If you cash out your old plan, even if you intend to put it right back into another account, those taxes and penalties we mentioned will come back to haunt you.

Am I automatically signed up for a 401(k) when I start a job? Many employers have now begun to enroll all their new employees. But just in case, talk to your human resources folks and make sure you're signed up for the plan.

Is a 401(k) worth the hassle? Absolutely. Even if your employer offers a mediocre selection of investments, you'll still be saving money on taxes while letting your retirement savings compound and grow tax-free. And we did mention the free money, right?

I like this "free money" stuff! Where can I learn more? We've got even more information on 401(k) plans right here at Fool.com.