401(k) plans are created by companies for their employees to allow them to save for retirement, have the savings invested, while deferring current income taxes on the saved money and earnings until retirement.

401(k)s are very common and popular and employers are allowed to automatically enroll their employees in them. If you are one of the participants, you probably know a lot about the 401(k)s already.

Some of the reasons the 401(k)s plans are so popular is that they have higher yearly contribution limits than the IRA, they may provide greater flexibility and are cheaper for employers to maintain.

The IRS sets limits to the amount of money you can contribute to a 401(k); for 2010 the limit is of $16,500 if you are under 50 years old and $22,000 if you are older and allowed to make catch-up contributions. In addition to the IRS limits, your maximum contribution limit may depend also on your plan and salary, for instance the maximum amount your employer allows may be as a percentage of your salary. The bright side is that there is no upper income limit capping your eligibility to the plan.

Your employer may contribute with a fixed amount every year. Another choice your employer has is to participate in a matching contribution, which actually means matching your contribution by a certain percentage of your salary and not the contribution you make.

Another popular method of employer contribution is through profit sharing contributions which will add a certain percentage of your salary into your account every year, regardless of whether you contribute or not.

Your employer’s contributions may be subject to vesting rules set by the plan requiring you as an employee to reach a certain number of years of service before you are entitled to keep the matching funds.

The funds in your account can be invested in a number of different stocks, bonds, mutual funds or other assets. Usually your employer will allow you to choose from a range of choices available in the plan. These investment options tend to find top performing, stable funds that will appreciate steadily over time.

There are two types of 401(k) plans that the IRS recognizes: the traditional 401(k) and the Roth 401(k), which was introduced in 2006.

In a traditional 401(k) your contributions are made with pre-tax dollars, meaning they are not included in your income tax return. Withdrawals from the account are considered normal income.

With a Roth 401(k) plan, contributions are made with after-tax dollars but you are allowed to withdraw the money tax-free at retirement. To qualify, your distributions have to be made more than 5 years after the first designated Roth contribution and not before the year in which you turn 591/2.

You are required to make distributions from your 401(k) account by April 1st of the calendar year after turning age 701/2 or April 1st of the calendar year after retiring, whichever is later. The required minimum distribution is based on life expectancy according to relevant factors from the appropriate IRS tables.

You may also opt for a lump-sum distribution if your plan meets the requirements set by the IRS.

If you withdraw money from your 401(k) plan before you are 591/2 you will have to pay a penalty of 10% on top of federal taxes you have to pay.

However, the IRS allows you to make a hardship withdrawal for certain specific reasons, such as paying for medical expenses, college tuition, avoiding foreclosure and so on. Taking a hardship withdrawal will put your contribution schedule on hold for 6 months.

Another advantage most 401(k) plans offer is that they allow you to take loans up to 50% or $50,000 of your vested balance, whichever is smaller. IRS rules say you have to repay the loan, with interest, within 5 years, otherwise the loan will be considered as an early distribution, incurring penalties and interest on the loan for income tax purposes.

In the eventuality of changing employers, you have several options for your 401(k) account:

• You can make a rollover to an IRA;
  

• You can cash out the proceeds, paying taxes and the 10% penalty.
  

Considering all these facts, it would be safe to say you can’t afford not to contribute to the 401(k) plan offered by your employer. In addition, you may qualify for an IRA plan as well, thus maximizing your retirement benefits.