How a 401(k) Works

Signing up for a 401(k) plan is very easy. Most times, you just fill out the paperwork provided by the employer and tell your employer what percentage of your income you want deducted from each paycheck. That amount is deducted before income tax withholding is calculated and put in a 401(k) plan account in your name. Social Security taxes are still assessed on the amount that goes into your 401(k) and the taxes are deducted from the rest of your paycheck.

Your employer may also have an automatic enrollment feature for its qualified retirement plan, which makes it even easier for you. Under this feature, you will automatically be included in the 401(k) plan, with a certain percentage of each paycheck going into your account. Your participation will remain unchanged unless you actually opt out of the plan or change to a different percentage.

Other than being able to part with some of your money, the hardest thing you will have to do when participating in a 401(k) plan is to decide how to invest it. A 401(k) participant alone bears the burden and the risk of making the right investment choices. Some plans offer many employer options, while others may offer only a few. Determining which of your investment options works best for you will depend on your particular situation and your investment strategy.

Contribution limits. The general rule that no deal is perfect applies to 401(k) contributions as well. The employer's plan itself will have a pre-set maximum percentage of income that you can defer from each paycheck. The government, afraid of losing tax revenues, further limits the maximum amount of money that you can put away on a tax-deferred basis.

The maximum amount that employees can contribute to a 401(k) plan under the tax code may vary from year to year due to adjustments for inflation. The annual dollar limits that an employee can defer to a 401(k) plan are as follows:

Starting in 2002, those age 50 and above can make additional catch-up contributions to a 401(k) plan. Under the catch-up contribution provisions, eligible participants can contribute an additional $5,000 in 2006, 2007 and 2008.

The catch-up provision was originally intended to aid women nearing retirement age who may be behind in saving for retirement because of interrupting their careers.

However, this is a great opportunity to save more money for anyone who has procrastinated or otherwise has not had the opportunity to invest in a 401(k) plan for very long. So if you are nearing retirement, don't miss out on your opportunity to increase your retirement nest egg.

Example Olivia, a 51-year-old participant in a 401(k) plan, earns $50,000 in 2007. Under her employer's plan, her maximum annual deferral limit is 10 percent of compensation. For Olivia, this means that she can contribute $5,000 to her 401(k) plan in 2007. However, because she qualifies for the catch-up provision, Olivia can contribute an extra $5,000 in 2007.

If you have caught 401(k) fever, you may be wondering why you can't contribute more to your 401(k) on an after-tax basis. The answer is that the limit on elective deferrals is a condition of a plan's qualification for favorable tax treatment. So, a 401(k) plan that allows excess deferrals risks disqualification.

However, the dollar limit on elective deferrals does not apply to employer matching contributions. For 2008, the maximum total contribution amount is the lesser of 100 percent of the employee's compensation or $46,000 ($45,000 in 2007; $44,000 for 2006).

Tip Nobody needs to tell you that earning more money is better than earning less. However, you may not have considered the fact that the more money you make, the more money you can save on a tax-deferred basis if your retirement plan is directly tied to your earnings. Consider this an added incentive to do all you can to boost your earnings potential.