401(k) fundamentals

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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 Most employee contributions are pretax and grow tax-deferred until withdrawn, but some plans allow after-tax contributions.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 The money grows tax free and can be later withdrawn on a tax-free basis.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.

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Rolling over your 401(k) plan
Unless your company has an outstanding 401(k) plan, you should consider taking the account with you if you leave the company. If you’re going to another company, you may be able to roll it over into the new company’s plan. If not, you can roll your 401(k) into an IRA at a brokerage. This gives you more control over your account and, in most cases, you’ll have much better investment options at a brokerage.

Just make sure you follow the proper procedures. The plan sponsor or the human resources department will assist you in transferring the money. You don’t want to accidentally cash out your retirement plan and get stuck paying taxes and penalties for early withdrawal.

Options for tiny businesses
If you’re an entrepreneur trying to maximize your retirement savings, consider opening an individual 401(k). A 401(k) plan used to be only for someone who worked for a corporation, but no more. Owners of very small businesses can now open 401(k)s and shelter thousands of dollars more than they could have in other self-employment retirement accounts.

The plans, often called individual or solo 401(k)s, are available to businesses that have no other employees beyond an owner and a spouse, although some partnerships can qualify. That means sole proprietors, owners of mom-and-pop companies, even people who work for someone else but have a side business, can open one.

The important thing to remember is, make use of the retirement options available to you. If a 401(k) plan isn’t offered at your place of employment, you can still save in other tax-favorable investments (such as IRAs). Explore your options, and put away 10 percent of your income (or as much as you can) for the future. This is called paying yourself first, and it’s probably the smartest investment move you can make.