When you join a 401(k) plan, you agree to set aside part of your salary in a special retirement account set up by your employer. You don't pay income taxes on your contributions to this account or on their earnings until you start taking money out of the plan. (Note: Pennsylvania is the only state that taxes 401(k) contributions in the year you make them.)

How is a 401(k) different from a regular pension?

The big difference is that you're in control: your 401(k) account is funded with your money and you decide how much to save and how to invest it.

A traditional "regular" pension is funded and controlled by your employer. The traditional plan is sometimes called a defined benefit plan because it promises to pay you a specific monthly income in retirement - in other words, a defined benefit. The amount you get is based on your salary and your years of service with the company. It's up to your employer to put aside enough money to make good on this promise; the contributions don't come from your salary.

Most defined benefit plans are insured by the Pension benefit Guaranty Corp., a federal agency. the PBGC guarantees to pay retirement benefits if the company doesn't have enough assets to cover them - but only up to a specified ceiling.

By contrast, a 401(k) plan is called a defined contribution plan because the annual amount that can be contributed to each employee's account is limited. A 401(k) plan is not insured and it doesn't promise a defined benefit. Your retirement income from a 401(k) plan will depend on how much you save and how well your investments perform.

How is a 401(k) different from a profit-sharing plan?

Technically, 401(k) plans are considered profit-sharing plans. But on a practical level, they're usually different in several ways from the classic profit-sharing plan. The biggest difference is that in what we think of as a profit-sharing plan, the employer makes contributions for eligible employees - in some cases, whether or not they also contribute to the plan. IN a 401(k) plan, by contrast, eligible employees must choose to participate by making their own contributions, which may or may not be matched by the employer.

How do my contributions lower my income taxes?

The amount you contribute to your 401(k) plan isn't reported as income on your W-2 form to the Internal Revenue Service.

The important thing about this tax break is that it makes 401(k) contributions much more affordable: Let's say Kate earns $25,000 a year. Her marginal federal tax rate is 28%, and her state and local taxes add up to another 4% for a total 32% tax rate. Kate contributes $1,000 a year to the 401(k) plan. That reduces her taxable salary to $24,000 a year. But it also cuts her income taxes by $320 (32% of $1,000).

Kate has saved $1,000 but her take-home pay isn't reduced by $1,000 a year. It's only reduced by $680.

Why is the government giving me this tax break?

Because it want you to save as much as possible for your retirement.

The government has opted to pass up current tax revenue in order to reduce the very real risk that you and millions of other Americans will wind up without enough money to live comfortably in retirement.

Why is that a real risk? Won't Social Security be there for future retirees?

Social Security will be there, but it's not a cure-all. In the first place, Social Security was never intended to be the only source of retirement income; it was supposed to supplement private sector pensions and individual savings. And in fact, that's all it does. The average Social Security recipient now collects $698 per month; the maximum benefit for a person who turned 65 in January 1995 is $1,199 per month. These are not princely sums.

Second, Social Security is grappling with serious problems that no one could have anticipated when it was enacted in 1935. The most obvious one is that people live a lot longer than they did 60 years ago. In 1930 the average American had a 59.7% year life expectancy at birth. Few people lived long enough to collect Social Security. In 1989 the average American had a 75.3 year life expectancy at birth. If you're in good health today at age 62, you may have another 30 years ahead of you.

The bottom line is that the average Social Security recipient today collects more in benefit dollars than he or she ever paid into the system in Social Security taxes. In other words, current Social Security benefits are funded by taxes paid by today's workers.

Given demographic trends, that's a serious problem. In 1950 there were 16 people in the workforce for every one retiree collecting Social Security. Today, there are only three workers for each beneficiary. By 2030 the ratio is expected to be just two to one. The upshot is that no matter how loudly politicians of both parties swear that Social Security benefits are sacred, down the road there simply won't be any choice but to make some changes. Congress will have to reduce Social Security benefits by increasing taxes (on current workers and/or on all but the least affluent benefit recipients) or by redefining the eligibility rules, probably both.

This explains why the government wants to make it easier for you to save for retirement on your own - and why it's critically important for your future security that you do so.