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What Is a 401(k)?

May 20, 2014

401(k)s and similar plans - 403(b)s, 457s and Thrift Savings Plans - are ways to save for your retirement that your employer provides, or "sponsors." You may hear people describe them as "defined contribution plans." That name comes from the fact that you make contributions to the plans - that is, you put your own money into them. (You may also hear your employer describe the plan simply as "The Company X Savings Plan.")

Here's how it works: You decide how much you want to contribute, and your employer puts the money into your individual account on your behalf. The investment happens through payroll deduction: You decide what percentage of your salary you'd like to contribute and, from then on, that amount comes straight out of your paycheck and goes into your account automatically, without you having to lift a finger. Your paycheck will be smaller as a result - though not as small as you might think, thanks to the tax benefits involved.

Your company serves as the "plan sponsor" for the 401(k), but it doesn't have anything to do with investing the money. Instead, the plan sponsor hires another company to administer the plan and its investments. The plan administrator may be a mutual fund company (such as Fidelity, Vanguard or T. Rowe Price), a brokerage firm (such as Schwab or Merrill Lynch) or even an insurance company (such as Prudential or MetLife).

Your employer sends your payroll deductions directly to the company managing your plan. But you are responsible for deciding how to invest your money among the options offered by your plan. Typically, a 401(k) offers five or more mutual funds that invest in various sectors of the financial markets. Some 401(k) plans also offer shares of your employer's stock.

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