For nearly twenty years, one of the most significant retirement investing tools has been the 401(k) plan. The 401(k) is set up by your employer and is designed to help you save (and build) money for retirement. The money you contribute to your 401(k) is pooled and invested in stocks, bonds, mutual funds, or other types of investments. You choose the type of investment from your company's list of options. Usually your contribution is deducted from your paycheck before taxes and goes directly into your 401(k) account.

If such a plan is offered where you work, there is no reason not to jump at the opportunity. Putting the money in a plan earmarks it for your retirement, and you don't have to pay taxes on it as the money grows. In addition, employers generally make a matching contribution, which can be as much as 10, 25, or even 50 percent of the amount you contribute.

There is a big difference between investing in a 401(k) and in a mutual fund that you can buy or sell at will. The IRS will not tax your 401(k) earnings as long as they remain invested in your 401(k). As soon as the money starts coming out, you'll start paying taxes on it. And if you withdraw money before a set date (usually when you reach 59½ years of age), you may have to pay a penalty. With a current mutual fund investment, you'll pay taxes annually on the dividends and capital gains your fund earns, whether you take the money out or let it continue to work for you.

If your employer is making a matching contribution to your 401(k) of, say, 10 percent of what you put in, you are already seeing a 10 percent growth on your investment, plus whatever gains the total investment accrues over time. It is a simple solution to retirement planning that you do not have to set up yourself. You do, however, need to keep tabs on where your 401(k) money is being invested. Too many people just make a choice and let it ride.

If you work in a nonprofit organization, you may be able to choose a 403(b) plan, which works similarly to a 401(k). Such plans generally have fewer investment options, but they are also tax-deferred. Government workers may be offered a 457 plan, which is also similar in principle to a 401(k) or 403(b), with some additional restrictions.

Your 401(k) Investing Strategy

Since you are in a retirement plan for the long haul, you need not worry too much about the days, weeks, or even months when the stock market is down. In fact, drops in the market can be in your favor as you continue to put money into the plan through payroll deductions. This concept, called dollar-cost averaging (described in Chapter 9), enables you to buy more shares of a stock or mutual fund when the rate is lower. In the long term, of course, the market will go up, and all those inexpensive shares will increase in value.

Since a 401(k) plan is a long-term retirement vehicle, it's important that you remember your long-term goals and stick to them. Focus on the long term and, as you approach retirement, maintain a solid assessment of how much money you will have when you retire and what your income will be. Besides Social Security benefits, you may have a pension plan and other savings.

All in all, the 401(k) plan is an excellent opportunity to build for your retirement and do so at the level you feel most comfortable. As one financial analyst puts it, “No matter what I say or suggest, the bottom line is that the individual has to be able to sleep comfortably at night.” It all goes back to risk tolerance. First, be proactive and don't just forget about the money in your retirement plan; second, determine what level of risk is okay for your 401(k).

Keeping Your 401(k) Through Job Changes

Regardless of when, why, or how often you change jobs, your 401(k) investment can retain its tax-deferred status. If your new employer offers a 401(k), you can have your existing investment directly transferred, or rolled over, to a new account.

In a rollover, the money in your 401(k) is never in your possession, and you can thus avoid paying taxes on it (at least for the time being). It goes from your old employer to your new one; in industry lingo, from direct trustee to direct trustee.

By law, employers have to allow you to roll over your 401(k). If you take possession of the money yourself, the company will issue you a check for your investment less 20 percent, the amount they're required to withhold and send to the IRS (where they treat it like an estimated tax payment) in case you don't roll the money over into another 401(k). You have to roll the money over within sixty days or you'll be hit with taxes and penalties, and you have to deposit the full amount of your rollover — including replacing the 20 percent your company withheld to avoid having that amount considered an early (and taxable) distribution. If you are not starting a new job or are joining a company that does not have a 401(k) plan, roll over the money into an IRA.

Taking Money out of a 401(k)

As soon as you hit age 59½, you're eligible to start taking money (called distributions) out of your 401(k), whether you're formally retired or not. Once you hit age 70½, you have to take out at least the minimum required distribution.

Sometimes people need to tap into their retirement funds early due to financial hardship, such as buying a primary residence, preventing foreclosure on your home, paying college tuition due in the next twelve months, and paying unreimbursed medical expenses. These withdrawals will cost you the full tax bill on the distribution plus a 10 percent penalty. You can escape the penalty under really extreme circumstances, but you'll always be stuck with the taxes. A better choice when you really need the money? A loan from your plan; many 401(k) plans allow loans, and there are no taxes or penalties at stake. The only caveat: The loan has to be repaid in full before you stop working for the employer who maintains the plan.