Money Essentials

Retirement: Virtues of the 401(k)

Uncle Sam doesn't offer many gifts. This is one.The upside: free money


If someone offered you free money, would you refuse it? Probably not. But that's just what you're doing if you don't contribute to your 401(k).

The more you contribute, the more free money you get. Here's why.

Contributing part of your salary to a 401(k) gives you three compelling benefits:

- You get an immediate tax break, because contributions come out of your paycheck before taxes are withheld, thereby lowering your taxable income.

- The possibility of a matching contribution from your employer -- most commonly 50 cents on the dollar for the first 6% you save, according to Towers Watson.

- You get tax-deferred growth -- meaning you don't pay taxes each year on capital gains, dividends, and other distributions

Thanks to the Tax Relief Reconciliation Act of 2001, there are a few changes to 401(k)s that may be of even greater benefit to you.

For starters, the federal limit on annual contributions is set at $17,500 for the 2013 tax year.

The Tax Relief Act also offers catch-up provisions for workers 50 and older. That is, those 50 and older now may contribute an additional amount, now set at $5,500, above the maximum allowable 401(k) contribution.

Keep in mind, however, while federal law sets the guidelines for what's permissible in 401(k) plans, your employer may set tighter restrictions. Plus, it may take time for the administrators of your plan to implement the changes.

What's more, there are other federal non-discrimination tests a 401(k) plan must meet, one of which applies to "highly compensated" employees. So if you make more than $115,000 in 2013, you may not be permitted to contribute as high a percentage of your salary as some of your lower paid colleagues.

For all its tax advantages, the 401(k) is not a penalty-free ride. Pull out money from your account before age 59-1/2, and with few exceptions, you'll owe income taxes on the amount withdrawn plus an additional 10% penalty.

Also, be aware of your plan's vesting schedule -- the time you're required to be at the company before you're allowed to walk away with 100% of your employer matches. Of course, any money you contribute to a 401(k) is yours.

(For a more detailed look at the 401(k), read Money Essentials: 401(k)s.)

calculator
Retirement savings calculator
glossary
Glossary
take the test
Take the test
more lessons
More Money Essentials
lessons
Features
They're hiring!These Fortune 100 employers have at least 350 openings each. What are they looking for in a new hire? More
If the Fortune 500 were a country...It would be the world's second-biggest economy. See how big companies' sales stack up against GDP over the past decade. More
Sponsored By:
More Galleries
Want to buy -- and live in -- a piece of history? It's not that far out of reach. These historic homes are not only for sale, they are incredible bargains. More
5 ways retailers are tracking you If you think pesky salespeople are invading your personal space, check out these 5 technologies that are tracking your movements throughout a store. More
Moto X vs. Droid Turbo: Which Droid should you buy? Motorola has made the two best Android smartphones this year. Here's how they stack up. More

Page has been updated for SEO on 11/23/2011 - abell
Updated for content 7/23/2012 - aross

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.