is currently in the middle of a special series on retirement accounts (Part 1). No matter your age or your current financial situation, you should always keep retirement planning high on your financial priority list. The 401k account is one of the most widely used retirement accounts. There are plenty of benefits to using the 401k, and those who don’t take advantage of them are making a big mistake. Let’s take a closer look at the 401k and how it works.

401k Plan Basics

A 401k plan is a qualified plan setup by an employer that allows eligible employees to make a salary deferral, or a salary reduction, on a post-tax or pre-tax basis. The employer typically sets this plan up with a brokerage or trust company and the plan generally offers multiple investment options for the employee. There are caps in place as to how much money an employee can defer into this plan on an annual basis.

The 401k plan is like most other retirement account types in that the employees must keep their money in this account until they reach 59.5 years of age or face a stiff 10% penalty. The account should be used only for retirement purposes. A 401k plan is generally only offered by large employers. Over the years more employers have started offering these plans because they see just how crucial this is to their employee’s long-term well-being. The 401k retirement plan got its name from Section 401 of the Internal Revenue Code.

Three Biggest Benefits of the 401k Plan

1. Terrific Tax Advantages- The tax advantages that come with the 401k plan are absolutely terrific. Realize that all dividend, interest, and capital gains are not taxed at all until they are disbursed. This means that your investments can compound tax-deferred inside your account for many years. It is also important to remember that the money you put into a 401k plan does not count as taxable income. For example, you could earn $40,000 in a year, but your taxable income would only be $35,000 if you put $5,000 into your 401k account.

2. Great Investment Options- Since a 401k is offered by large employers who are able to access top brokerages, the employee receives a multitude of investment options. You’ll often find that mutual funds available inside a 401k plan are some of the top performing funds. In addition, you can choose to contribute your money toward something such as a high interest stable value fund or a certificate of deposit.

3. Matching Contributions- Over the last few years, the trend has been for more companies to offer matching 401k contributions. Employers often offer a 50% matching contribution up to a certain percentage of your overall annual salary. Some employers even offer a 100%, or dollar for dollar, matching contribution. This is one of those rare cases where you free money really isn’t too good to be true. If your employer matches your contribution at 50 cents on the dollar, you could get $2,500 free each year if you defer $5,000 of your earnings. Indeed, there actually is a free lunch available for those who have matching 401k plans with their employer!

The 401k is the most popular employer sponsored retirement plan. Are you taking advantage of the great benefits associated with this plan? Or are you looking to transfer your 401k account to an different online broker?