How does a 401(k) plan work?

A 401(k) plan is a retirement plan offered to you through your employer. 401(k)s are the most common kind of defined contribution retirement plan.

Here's how it works: You decide how much you want to contribute, and your employer puts the money into your individual account on your behalf. The investment happens through payroll deduction: You decide what percentage of your salary you'd like to contribute and, from then on, that amount comes straight out of your paycheck and goes into your account automatically, without you having to lift a finger. Your paycheck will be smaller as a result - though not as small as you might think, thanks to the tax benefits involved.

Your company serves as the "plan sponsor" for the 401(k), but it doesn't have anything to do with investing the money. Instead, the plan sponsor hires another company to administer the plan and its investments. The plan administrator may be a mutual fund company (such as Fidelity, Vanguard or T. Rowe Price), a brokerage firm (such as Schwab or Merrill Lynch) or even an insurance company (such as Prudential or MetLife).

Your employer sends your payroll deductions directly to the company managing your plan. But you are responsible for deciding how to invest your money among the options offered by your plan. Typically, a 401(k) offers five or more mutual funds that invest in various sectors of the financial markets. Some 401(k) plans also offer shares of your employer's stock.