What the Fool Is a 401(k)?

What is a 401(k)? With a name only the IRS could love — based on the section in the tax code that gave it life — the 401(k) is a financial plan that lets employees contribute money toward their own retirements. It was created in 1980 to shift more of the responsibility for retirement savings away from employer-based pension plans.

How does a 401(k) work? Employers set up individual accounts for each employee who enrolls in their 401(k) program. Employees can contribute a pre-tax chunk of each paycheck to their 401(k), reducing their taxable income. Chip in $5,000 a year of a $40,000 salary, and the IRS will only make you pay taxes on the remaining $35,000. Better yet, money in your 401(k) account is completely shielded from the tax man’s clutches. Dividends, stock sales within the account, and other events that would ding you for taxes in a regular brokerage account are beyond the IRS’s reach in a 401(k). You’re only taxed on the money when you withdraw it in retirement.

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