What is a 401(k)?

A 401(k) is defined as a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

When you join a 401(K) plan, you tell your employer how much money you want to contribute to your account. This amount is deducted from your salary before taxes are applied, so you pay less income tax. What’s more important, the money is deducted even before you have received it, making it the easiest savings plan to contribute to. Your employer usually matches a portion of your contribution. The money is invested by the plan administrator on your behalf in mutual funds, bonds, money market accounts, etc. You decide the mix of investments. They usually have a list of investment options you can choose from as well as some guidelines for the level of risk you are willing to take. Since the plan is an incentive for retirement savings, there is one condition: if you withdraw the money before you are 59.5 years old, you will have to pay tax in addition to a 10% penalty fine to the IRS.