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What Is a 401(k) Plan?

A 401(k) plan is a retirement savings and investment plan offered by employers to their employees. Many employers like it because it costs less than a traditional pension plan; many employees like it because it can be more lucrative and gives them more control over their retirement income.

With a 401(k) plan, you can take a portion of the cash your employer would have paid you in wages and choose instead to contribute it to a tax-qualified retirement account, set up according to rules in section 401(k) of the tax code. You contribute the funds pre-tax, so you don't have taxes withheld on the portion of your income contributed. As a benefit of employment, many employers will match anywhere from 1 to 100 percent of your contribution to a 401(k) plan.

Most plans allow you to invest in many different kinds of instruments: different kinds of stock and bond mutual funds, money market funds, and guaranteed investment funds that pay a pre-set interest rate. You determine what portion of your contribution goes to each fund, and many plans let you transfer money among funds.

Unlike traditional pensions, 401(k) money is portable—you take it with you even if you change jobs.

Unlike traditional pensions, 401(k) money is portable—you take it with you even if you change jobs. Funds you withdraw are taxed at regular income tax rates. But there are severe restrictions and/or a 10 percent tax penalty on withdrawals before retirement.

Many plans do allow the option to borrow from your funds without taxation, as long as you pay the money back in a prescribed manner.

Employees of qualifying non-profit institutions may have a variation of this plan called a 403(b) plan. Non-profit employees who want to participate in a plan other than the one offered by their company can set up a 403(b)-7 account with virtually any company offering mutual funds.

If your company offers a 401(k) plan—especially one with an employer matching contribution—it will be worth your time to learn about it. An employer "match" is essentially free money, and employees are wise to take advantage of it by contributing at least enough to secure maximum employer matching funds, if possible. Even without an employer contribution, the 401(k) is a great opportunity to build resources for your retirement, and the automatic nature of your salary reduction contributions makes it nearly painless.