The name 401k refers to the section of the Internal Revenue Code that allows for this type of retirement vehicle. 401k's are tax-deferred retirement plans sponsored by company employers.
Generally, a certain portion of an employee's pre-tax income is deducted from his or her paycheck and deposited into the plan, producing an immediate tax deduction for the employee, not to mention deferring any future income and capital gains earned until the funds are withdrawn from the plan.
An employer can make up to three kinds of contributions to an employee's 401k: a basic contribution, representing a small percentage of the employee's annual salary; a matching contribution, based on the employee's contribution; and the employer's profit-sharing contribution. The funds within the plan are then invested by the employee in a number of eligible investments including stocks, bonds and mutual funds.
The current maximum annual contribution you can make to your 401k is $15,000 unless you are over the age of 50 and then it jumps to $20,000. Furthermore, for those over 50 whose employers allow catch-up contributions, the maximum for that is an additional $5,000. The benefits from maximizing your contribution are almost endless.
Here's an example that illustrates the benefits:
The total contributions in this example are $13,125. Of that, $9,000 would be your own, reducing taxes paid by $3,150 and your net contribution to $5,850. In return you would receive more than double that amount in tax-deferred investments.
This should drive home the point that maximizing your 401k is a critical tool in meeting your retirement goals.
However, there are some disadvantages. These include: