The virtues of the 401(k)

CNN Money

Uncle Sam doesn't offer many gifts. This is one. The upside: free money.

If someone offered you free money, would you refuse it? Probably not. But that's just what you're doing if you don't contribute to your 401(k).

The more you contribute, the more free money you get. Here's why.

Contributing part of your salary to a 401(k) gives you three compelling benefits:

  • You get an immediate tax break, because contributions come out of your paycheck before taxes are withheld, thereby lowering your taxable income.
  • The possibility of a matching contribution from your employer — most commonly 50 cents on the dollar for the first 6% you save.
  • You get tax-deferred growth — meaning you don't pay taxes each year on capital gains, dividends, and other distributions.
Thanks to the Tax Relief Reconciliation Act of 2001, there are a few changes to 401(k)s that may be of even greater benefit to you.

For starters, the federal limit on annual contributions is set at $16,500 for the 2011 tax year.

The Tax Relief Act also offers catch-up provisions for workers 50 and older. That is, those 50 and older now may contribute an additional amount, now set at $5,500, above the maximum allowable 401(k) contribution.

Keep in mind, however, while federal law sets the guidelines for what's permissible in 401(k) plans, your employer may set tighter restrictions. Plus, it may take time for the administrators of your plan to implement the changes.

What's more, there are other federal non-discrimination tests a 401(k) plan must meet, one of which applies to "highly compensated" employees. So if you make more than $110,000 in 2011 (the limit rises each year), you may not be permitted to contribute as high a percentage of your salary as some of your lower paid colleagues.

For all its tax advantages, the 401(k) is not a penalty-free ride. Pull out money from your account before age 59-1/2, and with few exceptions, you'll owe income taxes on the amount withdrawn plus an additional 10% penalty.

Also, be aware of your plan's vesting schedule — the time you're required to be at the company before you're allowed to walk away with 100% of your employer matches. Of course, any money you contribute to a 401(k) is yours.

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