I recently surveyed several friends to see whether they were maxing out their 401K's. To my surprise, many of them weren't. In fact, from general experience a lot of people ignore this seemingly no brainer piece of money management.
In short, the 401K is an investment vehicle designed to encourage savings by the government. You can contribute a maximum set amount it each year … in 2009, you can contribute up to $16,500.
The way the government "encourages" your participation involves taxation. You only pay taxes once on the money going into and coming out of your 401K. Normally, you would have to pay taxes on money when you earn it and on any gains thereafter. Essentially, if you use a 401K to invest, the government takes a lot less in taxes from you than it would otherwise. However, because the goal is to get you to save, you must wait until 59 1/2 years of age to begin tapping the savings account without penalties.
OK, not having to pay taxes is great on its own. But, on top of that, your employer often has match programs. For example, if you look at the benefits page for Google, Google matches up to 100% up to $2500 or 50% up to the contribution limit, whichever is greater. Let me sum that one up for you. If you contribute $16,500 this year at Google, you get $8,250 in free money from the company on top of that initial contribution. Granted, Google has great benefits, but other companies have quite generous match plans as well. If you had $8,250 sitting in front of you right now, would you just throw it away? Because if you aren't contributing to your 401K, you're doing something pretty close.
Now, due to the penalties, some people are worried about not having that money around to make a big purchase because there are penalties on taking that money out ahead of retirement. Generally, you can borrow against the 401K to do things like pay for college tuition or buy a home, so if you're worried about liquidity, you probably shouldn't be. Also, there are hardship clauses where you can take money out without penalty to deal with unexpected medical expenses, etc. In general, your 401K is liquid for you if you really need it to be, but it's not there to be abused.
The standard 401K is not taxed when income goes in. Taxation only happens when you pull money out at retirement. There is a second form of the 401K known as the Roth 401K. This plan allows you to contribute your after tax earnings now, and not get taxed when you start pulling the money out near retirement.
Why pick one over the other? Well, if you believe your tax rates will be higher near retirement, then taking the tax hit now is a pretty smart thing to do. In short, having climbed the corporate ladder (or whatever ladder you're climbing) and observing the spending patterns of the country in general, quite a few people are betting on their taxes being higher in retirement. In this case, the Roth 401K is a good idea.
If you're having trouble maxing out your contribution to leverage your company match, then you probably want to just do the standard 401K so that you get the maximum benefit from matching.
If you're already maxing out your contribution, then the Roth 401K can be pretty smart. In particular, independent of the whole taxation issue, using the Roth 401K lets you leverage significantly more money into the 401K. For example, if you think now is a good time to invest in general, then getting money into your 401K right now via the Roth is a great way to dump more money with the 401K tax advantage into investments than you could otherwise do with a regular 401K.
The bottom line is this. If you aren't maxing your 401K plan out, you're giving up a lot of free money. If you aren't sure whether you should be or not, then odds are you should be. Feel free to do your own research, but hopefully this gives some people a kick in the pants to check their contributions and start saving some money.