401(k) fundamentals

America's most predominant retirement plan enables you to save on a tax-favorable basis. It's an opportunity that everyone should take advantage of.

A 401(k) is an employer-sponsored retirement plan that's funded by employee contributions. These contributions are deducted directly from your paycheck. Many companies match contributions up to a certain percentage of salary. Most employee contributions are pretax and grow tax-deferred until withdrawn, but some plans allow after-tax contributions. As of January 2006, employers can offer Roth 401(k) plans, which are funded with after-tax contributions. The money grows tax free and can be later withdrawn on a tax-free basis.

401(k) plans are generally offered in the private sector. Government employees usually have access to 457 plans, while teachers and workers in the nonprofit sector generally contribute to 403(b) plans. While the structure of these plans may differ slightly, they all offer employees the opportunity to plan for a secure retirement.

One of the first considerations is how much money to contribute. Generally speaking, you should contribute as much as you can. You don't want to leave yourself cash-strapped, but you also don't want to squander the opportunity to make pretax, tax-deferred contributions and get a company match. Whether your company match is dollar-for-dollar or something smaller, don't pass up free money.

Even if you don't get a company match, it's a good idea to contribute to your 401(k) plan. Experts say you should strive to defer at least 10 percent of your salary for retirement. The earlier you get started, the more the magic of compounding can work for you.

For 2007, the maximum pretax annual contribution an employee could make is $15,500 ($20,500 if you're 50 or older). The limits are the same for 2008.

Making investment decisions
Employees are responsible for their 401(k) investment decisions. Most plans have an array of mutual funds to choose from, but too often there is little guidance as to proper asset allocation and the role fees and expenses play in overall returns.

Before you can decide how to allocate your contributions, you have to determine your risk tolerance. How much volatility within your portfolio can you stand?

If you're in your 20s or early 30s, you can afford to be more aggressive with your investments because you have more time to recover from slumps in the stock market. As you age, your asset allocation should shift to more conservative investments to protect the earnings.

Many 401(k) plans offer tools (online calculators, work sheets) for determining risk tolerance, but the best tool may be a competent financial planner. It might be worth hiring a planner to listen to your financial goals and evaluate your assets and earning ability to help you craft an allocation plan that will ensure a comfortable retirement.


-- Updated: Jan. 4, 2008

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