Most large employers now offer their employees a 401(k) retirement plan, sometimes called a "salary-reduction" plan.
Typically, the employer sets up the plan with an investment company, an insurance company or a bank trust department. You,
the employee, agree to put part of your salary into a special savings and investment account. Most 401(k) plans offer a variety
of investment vehicles, from individual stocks or mutual funds to money market accounts. Importantly, the money you invest
isnt counted as income when you complete your annual tax return. For example, if you earn $35,000 but put $5,000 into a 401(k),
your taxable income for the year would be only $30,000. Earnings that accumulate in the account are not taxed until you start
making withdrawals, usually after you reach age 59 1/2. If you withdraw earlier, youll have to pay taxes on the money and
a stiff 10 percent penalty. Most companies that offer 401(k) plans also match employee contributions. For example, the company
might add 50 cents to the account for every dollar contributed by the employee. That makes a 401(k) plan a much better vehicle
for retirement savings than an individual retirement account, which does not involve a matching contribution
401(k) Contributions Lower Income Taxes
Contributions to a 401(k) reduce your income taxes because the amount you contribute isnt reported as income on you
W-2 form to the Internal Revenue Service. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington
"The important thing about this tax break is that it makes 401(k) contributions much more affordable: Lets say Kate earns
$25,000 a year. Her marginal federal tax rate is 28%, and her state and local taxes add up to another 4% for a total 32% tax
rate. Kate contributes $1,000 a year to the 401(k) plan. That reduces her taxable salary to $24,000 a year. But it also cuts
her income taxes by $320 (32% of $1,000)."
Although contributions to some types of individual retirement accounts (IRAs) can be deducted, contributions to a 401(k)
plan cannot. It is important to note, however, that most people who contribute to an employer-sponsored 401(k) plan make those
contributions on a pre-tax basis. Such contributions lower the taxpayers adjusted gross income, which means they dont have
to pay taxes currently on the money they put into the 401(k). The taxes are deferred until the money is withdrawn. For example,
a taxpayer who earns $50,000 this year but contributes $2,500 of it on a pre-tax basis to the employers 401(k) would owe income
taxes on just $47,500 of his or her income.