• Employees of a private company, non-profit organization or government entity may receive retirement benefits from their employers. The most common benefit is a type of retirement savings plan called a defined contribution plan. The most common defined contribution plans are: 401(k), 403(b) Tax Sheltered Annuity and 457(b) Thrift Savings Plan.

In the past, employers often offered pensions. These defined contribution plans are today’s alternative to the traditional retirement pension and, for many people, the easiest and best way to save for retirement.

What is a 401(k) plan?

A 401(k) plan is a type of retirement savings plan that some private employers sponsor to help their employees save for retirement. As an employee, you can choose to have a portion of your paycheck — a contribution — paid directly into your individual account.

There are two types of 401(k) plans: traditional 401(k) and a Roth 401(k). These two plans are different in the way you are taxed on your money. Participants can choose from a list of investments, most commonly mutual funds.

• See also: Mutual funds

Most employers offer employer-matching contributions as an added benefit. Matching is when your employer agrees to put a certain percentage of money into your retirement account based on what you contribute.

• IRS 401(k) Resource guide: www.irs.gov/retirement/article/0,,id=151752,00.html

What is a 403(b) plan?

Employees of tax-exempt organizations — typically schools and non-profit organizations — may participate in a 403(b) plan. While the rules may vary slightly, 403(b) plans operate much like 401(k).

These plans also are called tax-sheltered annuities (TSAs) because past law only permitted employees to purchase insurance products called deferred annuities. Annuities provide income during retirement, but have relatively high costs that can limit their growth.

Today, most new plans offer mutual funds as options in addition to the different annuity options.

• See also: Mutual funds

Your employers’ match to your contribution can vary depending on the plan. If your employer offers a plan with a match, always take it.

• IRS 403(b) Tax-Sheltered Annuity Plans: www.irs.gov/retirement/article/0,,id=172430,00.html

What is a 457(b) plan?

A 457(b) plan is available for certain state and local governments and non-governmental entities tax exempt under the IRS code 501. This type of retirement plan is similar to a 401(k) or 403(b) plan because the employer provides the plan and the employee defers pre-tax income into the plan. Some employees get a match but it depends on the retirement system in which you belong. Most members of the military do not receive an employer match.

• IRC 457(b) Deferred Compensation Plan: www.irs.gov/retirement/article/0,,id=172437,00.html

Why should I contribute to a 401(k) instead of an Individual Retirement Arrangement (IRA)?

Many people are able to contribute more pre-tax money from your paycheck using a 401(k), 403(b) and 457(b) plan than with an IRA account. The contribution limit for 401(k)s in 2010 is $16,500. The contribution limit for an IRA account is $5,000.

Some employers offer an employer matching contributions to part or all of their employees’ contributions as an added benefit. Employee and employer-combined contributions are limited to 100% of employee's salary or $49,000, whichever is less.

If your employer offers a match — take the match. Don’t leave that free money sitting on the table. Contribute every dollar you can up to the amount that your employer is willing to match. Then, consider saving more than the match. Your total retirement savings should be at least 10% of your income each year if you started saving in your 20s, or closer to 15% or more if you waited to start saving.

Today, most employers are allowed to automatically enroll their employees in 401(k) plans, requiring employees to actively opt-out if they did not want to participate. Companies that have automatic 401(k) investment set a default saving rate and investment fund for employees who are auto-enrolled. Employees must then adjust their options or opt-out.

How much you should contribute?

Once you are eligible for benefits at your job, you’ll receive information for setting up your plan. The first think you will need to do is figure out how much to contribute. This is determined as a percentage of your paycheck. You’ll need to do some math and figure how much you can budget. Make sure you’re maxing out the match and ideally saving at least 10% of your gross pay including any match. Never leave free money on the table.

401(k)s, 403(b)s and 457(b)s are subject to contribution limits, so you’ll want to check each year to see the maximum amounts that you can contribute.

• See also: Current year contribution limits

Choosing a plan

Next, you’ll choose your investments. You should make selections based on how aggressive or conservative you want to be and the types of investments you want to make. Usually, it will be a list of well-known mutual funds that are easy to look up and learn about through sources such as Yahoo Finance and Morningstar.

• See also: Mutual funds

Typically financial advisers recommend that you start investing when you are young, because the younger you are, the longer you have to benefit from compound growth, Remember, it’s your savings rate not the investment rate that makes it all work.

When starting to plan your long-term retirement goals, you may want to consider working with a financial professional.

• See also: Financial professionals

Taking money out of plans

When save for retirement, the goal is to put money in and let it grow until you are retired. You’ll lose the tax benefits of your retirement saving plans if you take your money out too early.

You can start to take money out of your 401(k), 403(b) and 457(b) accounts after you turn 59 ½. If you take money out before that, you’ll usually have to pay penalties in addition to having to pay federal and state income taxes on what you take out.

Rolling over your plan

Don’t forget about your 401(k) when you switch jobs — rollover or transfer the money to your new employer’s retirement plan, or to a rollover IRA. Too many people just cash it out and pay a pile of money in taxes and penalties. Just as free money is good, abandoning large sums of it is bad.

What are the tax benefits and rules?

Contributions to 401(k)s, 403(b)s and 457(b)s offer savings immediately on contributions and tax-deferral of any investment earnings. During your work life, you may set aside money in a retirement savings plan. Money you set aside is tax-deferred — you do not have to pay income tax on it until you receive it and are able to spend it. When you retire and withdraw the money, you must claim it as income and pay taxes.

Taxes on investment earnings are also deferred — so you don’t pay taxes on anything you contribute or earn until you retire

The above description is true of traditional plan contributions, but a Roth 401(k) is a bit different mainly in the way your contributions are subjected to tax.

Traditional 401(k) taxes

 In a traditional 401(k), you contribute money straight from your gross pay. That means if you earn $40,000 a year and contribute $5,000 to your traditional 401(k) — you only report $35,000 in job income on your tax return. As long as you leave the money in the retirement plan, it is not taxed until retirement.

Roth 401(k) taxes

If your employer offers this type of 401(k) account and you elect it, your contributions are added on an after-tax basis. This means the income you report on your tax return will include the contribution, so there’s no up-front tax benefit. However, the plus side is that as long as you follow the rules — leave the money in the account until retirement age — all of the earnings of the account to due to investment income and capital gains is tax free, which over the long run, can be huge tax savings.

Roth 401(k)s are a good option if you:

• Get no tax benefit from pre-tax contributions from a traditional 401(k)

• Expect to have a lot of retirement savings relative to the average person

• Are worried that future income tax brackets will be much higher than they are today

Early withdrawal penalties

Since you are supposed to use the money from your retirement savings plans during retirement (after age 59 ½ in most cases), there are penalties if you take out funds before then. The federal penalty is 10% of the taxable amount withdrawn, and your state may have a penalty as well.

If you take out a loan against your 401(k) and change jobs before the loan is repaid, it’s often immediately payable. If you fail to come up with the necessary cash for the loan repayment, the government will call the unpaid debt a deemed distribution from the 401(k), then tax it and — assuming you’re younger than retirement age — penalize you 10% for an early withdrawal of the money.

For all these reasons, we recommend that you never borrow money from your 401(k).

Contribution limits

The contribution limit for defined contribution plans changes annually.

• See also: Current year contribution limits

The contribution limits on defined contribution plans are higher than. How much income you earn can affect your contribution limit.

You should always contribute at least 10% to retirement — as your salary increases, so should your contributions to your retirement accounts. If you max out your defined contribution plan but are not saving 10%, consider saving more with an IRA or with an investment account.

Words to know

Unsure about something you read? Many of the financial terms you came across in this article are defined in our financial glossary. A-Z Glossary

Links we like

Here are a couple online features you might find useful:

• Internal Revenue Service-Retirement: www.irs.gov/retirement

• TIAA-CREFF: www.tiaa-cref.org/plansponsors/resources/retirement-plans/specifications/403b-plans/index.html

• Thrift Savings Plan: www.tsp.gov