In all likelihood, you will have to deal with a 401(k) at some point in your life. The good thing is they are fairly straightforward and investing in them is easy and potentially very profitable. Understanding the basics of a 401(k) might prove very beneficial.

401(k) Basics

Let’s start with the simple definition. A 401(k) is a retirement savings plan offered through your employer. It is sometimes referred to as a defined contribution retirement plan. The account is funded through a pretax payroll deduction. This means each month your company removes a percentage of your salary and sends it to your 401(k) account automatically.

Some companies match a percentage of your contribution. For instance, if you contribute $2,000, your company might match 50% of that contribution, which would mean $1,000 more in your 401(k) account. While your company serves as the sponsor of the 401(k), a different managing company actually invests the money. You won’t be picking which specific stocks and bonds to buy, but usually you can select among various mutual funds.

Advantages of a 401(k)

There are several advantages of a 401(k) plan. Employers will often match contributions you make to the account, as noted above. Also, the money invested in your 401(k) is removed from your paycheck before income taxes are calculated. That means you don’t pay any income taxes on that money. Additionally, you don’t pay any taxes on investment returns that come from your 401(k) which means no capital gains taxes. Unfortunately, you do have to pay regular income taxes when you withdraw the money at some point in the future.

What are the varying account types?

While the 401(k) is very well-known, other retirement plans exist. A Roth 401(k) is similar to a 401(k), but functions in an opposite way. You pay taxes on all contributions, but withdrawals are tax-free. This plan might be a great option for younger employees who are in a lower tax bracket. Sure, they don’t receive the contribution tax-break, but they aren’t sacrificing much of a tax-break anyway.

Other defined contribution plans similar to a 401(k) exist for government employees. A 403(b) retirement plan is specifically designed for employees of the government or tax-exempt groups like schools, hospitals, and churches. A 457 plan is available for state and local employees. The Thrift Savings Plan (TSP) is geared for members of the uniformed services.

Why would an employer offer a 401(k) if it costs them money?

If your company matches a percentage of your monthly 401(k) contribution, that could mean tens or even hundreds of thousands of dollars of additional revenue over the course of a lifetime. For a large company, matching contributions costs them an average of $25 million a year. Many people wonder, why would a company fork over so much money for free?

The answer lies in competition. Companies are well aware that employees pay keen attention to health benefits and 401(k) matching. If they don’t offer to match contributions, they will undoubtedly have trouble winning over talented employees. However, in the wake of the economic downturn, some large companies eliminated matching contributions. As the economy improves though, companies fully expect to restart matching.

What are the rules on how much you and your employer can contribute?

The government places certain limits on how much you and your employer can contribute to your 401(k) on an annual basis. These limits shift each year due to inflation. For 2011, if you are under 50 years old, you can contribute $16,500 ($17,000 in 2012). If you are 50 or older, you can contribute an additional $5,500 for a total limit of $22,000. These limits only apply to the money you contribute, not your employer’s matching contribution. Your employer is subject to a different limitation. They can match 6% or less of your pre-tax compensation.

Before you make any 401(k) decisions, be sure to study your company’s specific plan and don’t be afraid to ask questions. A little research now will mean big savings for the future.