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401K Plans

Named for a section of the Internal Revenue Code, 401(k)s may not have the catchiest name, but they have definitely caught on since their introduction in the 1970s. With many popular features, 401(k)s are the most common defined-contribution retirement plan in America today.

Employees have taken to these plans, in part, because they can make contributions on a pretax basis (before taxes are deducted from paychecks).

Employers often encourage participation by contributing money to the accounts. Usually, the employer's contribution is determined by a formula connected to the employee's contribution level. For example, an employer might match 50% of the first 5% of salary an employee contributes. Employer contributions are not taxed as salary, but are taxable when you withdraw them at retirement.

When companies offer to match your 401(k) contributions, "highly compensated employees" (generally, those with annual salaries above $85,000) have to think doubly hard about how much to contribute from each paycheck. If they set their contribution rate too high, they could reach the maximum before the year is up. When they don't contribute, the employer's match is zero, forcing the employee to miss out on free money. If you're fortunate enough to have this dilemma, you should calculate a deferral percentage that leaves you just under the cap by year's end.

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