Taking Care of Your 401(k)

Now that the economy is producing jobs at a healthy pace again, if you're changing jobs you may need a refresher course on 401(k) retirement savings plans -- especially if, like many people, it's been years since you've paid much, or any, attention to it.

About 51 million people contribute an average of 8% into these self-directed retirement plans, which have largely replaced company-sponsored pension plans and may now be more important than ever with Social Security reform growing more likely in the coming years.

Experts say too many people fail to take full advantage of their 401(k), through inadequate participation, neglected allocation and unnecessary withdrawals, all of which will very likely crimp retirement finances.

"These make a very large percentage of employees into money managers, whether they thought they were going to be or not," says Don Cassidy, an analyst at Lipper.

How They Work

Generally, a person is allowed to contribute a maximum of $13,000 of pre-tax salary, which is invested in an assortment of mutual funds through a company sponsored plan. Many companies match employee contributions, though few exceed 6%.

Though there are limited exceptions, withdrawal prior to the age of 59 1/2 triggers sizable tax penalties. After that, income from 401(k) withdrawals is taxed as ordinary income based on your applicable tax bracket, whether you are employed or retired.

The point of the plan is to maximize investment growth by allowing savers to invest untaxed income, whose return on investment is also untaxed, creating a larger -- assuming good investment selection -- pool of money at the end.

Mark Schwanbeck, a former pension fund manager and author of Your 401(k) Handbook, explains it this way: A person earning $30,000 a year sets aside 8%, or $2,400 a year, for his 401(k). That cuts your taxable income to $27,600, which reduces the overall tax burden.