Retirement 101: What is a 401(k)?

June 8, 5:43 PMBusiness and Finance 101 ExaminerAndy Samuels

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A 401(k) plan is a retirement plan whose name refers to the section (401) and paragraph (k) of The Tax Reform Act passed in 1978. This section of the Tax Reform Act created a government incentive for individuals to save more money for retirement. It allows people to devote a portion of their pre-tax salary to a retirement fund that is managed by a third party who invests that money in mutual funds, bonds, stocks, etc. Usually people do have some choice on where their money is being invested based on the level of risk they are willing to take.

The best part about the plan is that your employer will often match a portion of your contribution, in essence, giving you “free money” that you would have otherwise foregone if you did not participate in the plan – this is your incentive to invest in the 401(k). The only drawback to the plan, other than the inherent risks in investing, is that if you withdraw your money before you are 59.5 years old, you will have to pay the tax on it, as well as a 10% penalty fine to the IRS. The interest from the 401(k) is compounded meaning that the earnings are automatically reinvested, and the money in your 401(k) grows tax-free until withdrawn. Both of these facts are a major plus in the long-run, so the sooner you get started with a 401(k), the more amplified the positive effects are.