401(k) Plan

A 401(k) is a tax-deferred investment and savings plan that acts as a personal pension fund for employees. (The name refers to the relevant section in the tax code.)

If you are a business owner a 401(k) may be best if your company is in need of a customized retirement solution. These retirement plans are appropriate for a start-up business or established business of any size. Contributions to the plan are tax deductible and earnings grow tax-deferred but are taxed when participants withdraw them. In order to establish a plan the company has to have one or more employees. The plan needs to be established by December 31 (of fiscal year end). Employer contributions must be made by business tax-filing deadline.

For the employee a 401(k) can be a powerful retirement vehicle. This plan lets you defer taxes on a portion of your salary until you retire. Contributions are automatically deducted from your paycheck. In 2006 an employee can contribute up to $15,000. If you are over the age of 50, you have a catch up provisions that will allow you an additional $5,000 in 2006.

Many employers match employee contributions, usually in the range of 15% to 50%. For example, let’s say you make $50,000. Your employer matches your 401(k) contribution dollar-for-dollar up to 6% of your salary, which for you amounts to $3,000. In this case, the first $3,000 of savings should go into your 401(k) plan. While your own contributions always belong to you, you may have to wait a few years to be fully vested in the company’s match.

Plan participants usually have a choice of investments, including stocks, bonds and fixed income funds. Some employers restrict investments to their own company’s stock. Many 401(k) plans allow you to borrow from your nest egg. Generally, you must pay back the loan within five years, but you may owe a 10% penalty and taxes if you haven’t paid the money back when you leave the company. The law allows you to make early withdrawals in certain cases of economic hardship, but you will get caught by the 10% penalty unless you are disabled, you leave your company at age 55 or later, or you need the money for medical expenses exceeding 7.5% of your adjusted gross income.