As we explained in Chapter 1, a 401(k) is a tax-deferred account similar to an IRA (see Chapter 3), with a couple of important exceptions: you contribute to your 401(k) directly from your paycheck, and the money you contribute is pretax regardless of your income. These features make 401(k)s a little easier to manage than IRAs.

Your employer has gone through the trouble to set up the account and has selected a variety of investments for you to pick from. Your contributions are easily made from your paycheck, and you don’t need to keep track of eligibility rules and caps on deposits; your employer does that for you.

But you can contribute to the 401(k) only while working for your current employer. If you don’t have an account at your current job, but you do from a previous job, you can’t contribute to the old plan unless you convert that account to an IRA. We give more detail on changing jobs and managing old 401(k) accounts in Chapter 8.

You can contribute more to a 401(k) than you can to an IRA. In 2008, you could contribute up to $15,500 or 100 percent of your pay, whichever is lower, to your plan. If you are age 50 or older, you could add a catch-up amount of $5,000, for a total of $20,500. Both of these limits increase with inflation starting in 2009.

As part of an overall benefits plan, your employer might also contribute to your 401(k) account. This amount is in addition to your salary and gets the same tax treatment as your contributions do. Contributions are not taxable to you when deposited into the account but are taxed as income when withdrawn.

Companies can choose how much they want to put into employees’ accounts, with a few restrictions to be sure all employees are treated fairly. Contributions are made as profit sharing or matching contributions that depend on how much an individual is contributing. Under profit sharing, which interestingly has nothing to do with whether your company is profitable, the employer can decide each year whether to contribute to the employees’ plans.

Matching contributions mean that the employer promises to match a certain percentage of each employee’s contribution up to a specific percentage of her pay. Many employers match all of the first 3 percent that a person contributes, and others match 50 percent of the first 6 percent that one contributes. The matching feature is the employer’s way of encouraging workers to contribute to their 401(k) accounts. The first matching example encourages employees to put at least 3 percent into their plan. The second puts the bar a little higher—at 6 percent—but the result in both cases is a maximum match from the employer of 3 percent of the employee’s salary.

More and more employers are establishing safe-harbor 401(k) plans to save themselves the effort and cost of running the nondiscrimination tests each year.

Safe-harbor plans make employer contributions 100 percent vested immediately, just like your personal contributions.

Not everyone can afford to contribute to a 401(k). The IRS might allow you to put $15,500 into your account, but that doesn’t mean you can afford to! What often happens is that the higher-paid people in the company want to put the maximum they can into the 401(k), and the lower-paid people put less than the maximum. ERISA rules require that the plan be fair for everyone and define certain tests the plan must pass to prove it’s treating everyone fairly. The matching formulas and profit-sharing contributions that companies use are related to meeting these tests.

Your own contributions to your 401(k) plan are always 100 percent vested. This means that when you leave your job, you can take the amount you have put into the account with you—it’s not forfeited to your employer. The contributions your employer makes may not be as portable, though. A vesting schedule dictates when the contributions your employer makes to your account really become yours.

There are two types of vesting schedules: cliff and graded. Cliff vesting is an all-or-nothing proposition. Not a penny of your employer’s contribution is yours until you reach a specified work anniversary, and then every dime is yours. Because 401(k) plans and employer contributions are an important part of attracting new employees, most employers who use cliff vesting allow employees to vest at three years or they use a graded vesting schedule. Under graded vesting, employer contributions vest in stages or grades. In many cases you may be partly vested as early as your second anniversary. The first grade is usually 20 percent, and then your vesting percentage increases each year until you are fully vested after completing five years of service.

The book of rules that govern your specific 401(k) plan is called the Summary Plan Description (SPD). Your human resources department will give you a copy of the Summary Plan Description when you start work, or it might be available on the company website.

The SPD outlines when you’ll be eligible to participate and the specifics about how to contribute to the account and how to withdraw money. Most companies allow employees over age 21 to start participating in their 401(k) fairly quickly—usually within 30 to 90 days of joining the company—but the employer match might not start until you’ve been with the company longer. Don’t let the delayed match feature discourage you from starting your contributions. Remember, your retirement security is up to you, and a 401(k) plan is a great tool to have in your retirement toolbox.

You need to list a beneficiary on your 401(k) account and keep the designation up-to-date. Like your IRA and other retirement plans, your 401(k) assets can pass to your beneficiaries directly without waiting for the probate process and your will. Also, the beneficiary can choose to continue the tax-deferral you started by leaving the money in the 401(k) or transferring it to an IRA (see Chapter 13). So be sure to list a beneficiary on your 401(k) account and update it as needed.