One of the best things Congress ever did was create the 401(k) plan, an employer-sponsored retirement plan that gives a special tax break to employees saving for retirement. Here's how the tax break works: If you contribute $2,000 a year and you're in the 28 percent federal tax bracket, you'll save $560 because the $2,000 is deducted from your pay before your taxes are calculated. If you live in one of the states where 401(k) contributions are tax-deferred, and you're in a 6 percent state income tax bracket, you'll save another $120 in state taxes, for a total savings of $680.

The bottom line is that you add $2,000 to your investment account but only $1,320 comes out of your pocket ($2,000 – $680 = $1,320). It's like getting a raise. You don't pay taxes on your earnings until you withdraw them, presumably at retirement, so your investments grow faster as your untaxed earnings benefit from compounding.

Employer Match

To sweeten the pot even more, many employers match a certain percentage of your contributions. The amounts vary but a typical match is between fifty cents and $1 for every dollar you contribute, up to 6 percent of your salary. Even if your employer doesn't contribute, 401(k) plans are great, but if a match is offered and you don't participate, it's like walking past money lying on the sidewalk and not picking it up. Where else are you going to find a guaranteed 100 percent return on your money (assuming your employer matches dollar for dollar)? Actually, the return is greater than 100 percent when you factor in your tax savings.

Contribution Limits

The IRS sets limits, adjusted annually for inflation, on how much you can contribute to a 401(k) plan each year. For 2007, you can contribute up to $15,500 as long as it doesn't exceed 100 percent of your earnings. Once you reach age 50, you're allowed to make additional “catch-up” contributions. The total of all contributions, including yours and your employer's, cannot exceed 100 percent of your compensation for the year, or $45,000, whichever is less. These limits are increased periodically to adjust for inflation.

Your employer is subject to strict IRS regulations to ensure that your 401(k) plan doesn't discriminate against lower-paid employees. If you're a highly compensated employee, your contributions will be limited by how much the less highly compensated employees contribute. Highly compensated employees are defined as those who made $100,000 or more in the prior year or owned 5 percent or more of the company. Your employer may have adopted a safe-harbor provision that does away with the limits for highly compensated employees by making a certain level of matching contributions or nonelective employer contributions for all eligible employees.

401(k) Vesting

You're always 100 percent vested in your own contributions to the plan. The employer match is often subject to vesting, which means you earn the right to it gradually, over a number of years of employment with the company. There are two types of vesting schedules. About half of all 401(k) plans have cliff vesting, where you don't own any of the matching contributions until you've worked for the company for a certain amount of time. The Tax Relief Act of 2001 shortened the maximum vesting schedule for cliff vesting to no more than three years. The other type of vesting schedule is graded vesting, where you own an increasing percentage of the employer match over several years. Under the Tax Relief Act of 2001, vesting must take place in no more than six years. A typical vesting schedule will now be 20 percent after the second year, 40 percent after the third year, 60 percent after the fourth year, 80 percent after the fifth year, and 100 percent after the sixth year.

It's important to consider the impact on your 401(k) when you're thinking of changing jobs. If your plan has cliff vesting, and you leave before working the required number of years, you walk away from everything your employer has contributed as matching funds, which could be a substantial amount. You could possibly earn thousands of additional dollars in company matching funds by staying in your current job for a few more months or years. Let's assume you had matching contributions of $6,000 and a vesting schedule of 20 percent per year for five years. If you left for a new job after three years, you'd take $3,600 ($6,000 × 60 percent = $3,600) of matching funds with you, plus all the contributions you made from your salary and any associated earnings.

Good deal, right? Yes, but it could be better if you stayed longer. You'd forfeit $2,400 ($6,000 × 40 percent = $2,400) plus any earnings that money has accumulated. You could miss a whole year's worth of vesting by leaving a month or week before your vesting date. Congress is considering changes to the law that would shorten vesting periods, making it easier for you to take matching funds with you when you change employers.

Switching Jobs

The portability of 401(k) plans is a great feature, but what do you do with your money when you change jobs? You have three choices:

• If you have over $5,000 in your account, you have the option of leaving your funds in your employer's plan.

• You may be able to roll your balance over into your new employer's plan.

• You can set up an individual IRA at a bank, through a broker, or directly with a mutual fund.

401(k) Loans

If your 401(k) plan allows loans, you can borrow up to 50 percent of your vested balance, not to exceed $50,000. Loans typically have to be repaid over no more than five years unless the funds are used to buy a first home. Interest rates are typically low — between one and three points above the prime rate. Because you pay yourself back instead of paying a creditor, 401(k) loans are touted as a great deal. Even the interest you pay goes back into your 401(k).

But it's not as simple as it sounds. The first reason you should avoid borrowing from your 401(k) if possible is the tax consequences. Your repayments are not tax-sheltered. They're made with after-tax money. If your monthly payment is $200 and you're in the 28 percent federal tax bracket and a 6 percent state tax bracket, you'd have to make $303 to net enough to make the payment. Worse, when you retire and take withdrawals, you pay taxes on that money again. The second reason you shouldn't borrow from your 401(k) is the opportunity costs. The money that you borrow could be earning interest or appreciating if you left it in your plan. Over time, the impact on your 401(k) could be substantial.

If you have a loan balance when you leave your job, you'll be required to repay the loan immediately. If you don't, you'll owe federal and state income taxes on the amount you borrowed, plus a 10 percent early withdrawal penalty. Think carefully before borrowing your retirement funds, and do so only if you need the money for something important, such as a down payment on a house, and you have no other alternatives. Never borrow from your 401(k) for something like a vacation or a new car.