By: A.J. Cook


The 401(k) plan is probably the most popular tax shelter both large and small employers provide for employees. But what is it?

It's a retirement plan that puts you in the driver's seat. Like other retirement plans, contributions are usually deductible, and tax on income is postponed. But with the 401(k), you, the employee, have an option – have part of your compensation go into the fund and delay the taxes, or pocket the compensation and pay taxes now. A regular retirement plan doesn't offer this option.

It's popular among employers because it can be a low cost method to provide a tax-deferred retirement savings for employees.

Most 401(k) plans allow you to contribute a percentage of your pay, generally between 1 - 15%. For 1998, the law limits the contribution to $10,000. But for employees receiving more than $80,000 annually, this is further limited. A complicated formula restricts people with fat paychecks from saving the maximum unless many of their lower paid colleagues also participate.

In some companies, the firm matches employee contributions. For example, an employer contributes 50 cents for every dollar contributed by the employee.

Most withdrawals are taxable. If an employee never paid taxes on money put into the fund, that money plus the earnings on it are taxed when withdrawn.

Withdrawals before age 59½ can result in a 10 percent penalty, in addition to the tax. There are various exceptions, including the following:

• The participant dies or is disabled.
  
• The funds are used for major medical expenses or health insurance for an unemployed person.
  
• The funds are distributed as lifetime annuity payments.
  

After 1997, penalty-free withdrawals are permitted to pay certain higher education expenses and to fund up to $10,000 of a first home.

Each firm offering a 401(k) sets out specific provisions in a written document. For example, some plans allow participants to borrow for certain emergencies, such as preventing eviction or foreclosure on their home. For an outline of all provisions, ask your employer for the Summary Plan Description.

PLANNING TIP: For many workers, the money in their 401(k) is the largest asset they have. Putting money in makes good sense for two reasons:

First, taxes on most of the contributions and earnings on them are deferred, so savings grow more rapidly than they would otherwise. For example, consider that a person puts aside $9,000 a year for 20 years. After current and deferred taxes are paid, the participant could easily have $100,000 more with a 401(k) than the person who saved outside a plan.

Second, some firms match contributions. For those fortunate participants, a contribution by an employer is like getting a raise.