A 401(k) is a type of retirement plan an employee enters into through his or her employer. As one of a few defined contribution plans, a 401(k) relies on a certain amount to be contributed yearly, with taxes and penalties applicable in the case of early withdrawal. There are different types of 401(k) plans available depending on the particular employer. In most popular plans the employer agrees to match employee contributions, which will double the amount of money invested each year. Other 401(k)s do not come with an employer contribution, but the advantage is still there because funds going into the 401k are contributed before taxes come out of an employee paycheck, lowering the taxed amount.

The employer is responsible for designating the 401(k) retirement plan for his or her employees, and each employee must, in turn, choose what portion of his or her monthly salary he or she wishes to contribute to the plan. The money is then invested in certain stocks, ranging from low to medium risk, where it collects interest. The more money invested, the more potential interest can be collected. An employer can co-contribute as much or as little as he or she wishes for each employee and may also choose where the money is invested. The plans are backed by the federal government, which means that if an employer goes bankrupt, the retirement investment will not be touched by creditors.

For employees who choose to participate in the plan, 401(k) can be an excellent retirement fund. The selected yearly contribution comes out in one month increments prior to taxes, which lowers the amount of taxable income. In plans where employers match all or some of the individuals contribution, the retirement fund can grow substantially over several years. All 401(k) plans require the employee to invest the money for a certain amount of time or until the employee reaches age 50.5. In the case of early withdrawal, the employer and the IRS will impose a penalty on the total amount withdrawn as taxable income. If the employer contributes partially to the fund, the employer may also impose what is called a vesting period. A vesting period is the period of time before the money invested by the employer actually belongs to the employee. A common vesting period is around three years. This means that as a 401(k) plan contributor, the employee does not own the employer’s matched funds until three years after the employer’s matched funds are invested.

A company’s 401(k) plan can be a great option for anyone with a stable job looking for a retirement plan. 401(k)’s are low risk investments with moderate returns, and are federally backed. It is possible that an employee’s investment can be doubled by his or her employer, and all money is taken out pretax, which lowers the taxable amount of employee income. Because a 401(k) is a retirement plan, financial penalties do apply for early withdrawal, but as a long term investment a 401(k) can be quite lucrative.