Q: What are the tax advantages of 401(k) plans?

A: For starters, when you contribute to a 401(k) plan, you don't have to pay income taxes on the amount you contribute until you make withdrawals. Plus, your earnings grow on a tax-deferred basis. So you get an instant payoff in current tax savings and your nest egg grows faster than it would in a currently taxable investment. For example, if you contribute $5000 a year to your 401(k) plan, and you’re in the 28% marginal federal income tax bracket, you’ll save $1400 in federal income taxes alone.

Q: Can I withdraw money from my 401(k)?

A: While you're with your employer, you generally can't make outright withdrawals unless you face strictly defined financial hardships. And even then you’ll have to pay income taxes, and if you’re under age 59 ½, a 10% early-withdrawal penalty. By the time you’re done, you’ll be left with only about half your account.

Plus, once you’ve made a withdrawal, you’ll probably have to wait a year to resume making contributions. In the meantime, you’ll lose out on all those tax-sheltered salary deductions, as well as any matches your employer makes. What’s more, you can’t replace the amount you withdrew later on.

Q: Should I borrow from my 401(k), if necessary?

A: Typically, you can borrow as much as 50% of your vested account balance, up to a maximum of $50,000. You have to repay loans within five years, unless it’s to buy a home, in which case you have as long as 30 years.

You’re usually allowed to borrow for any reason, and the rates are generally favorable. However, some financial experts generally advise only doing so for serious purposes such as medical emergencies, your child’s college education, or for a down payment on a home. That’s because there are some pitfalls. Specifically, if you quit or lose your job, you usually have to repay an outstanding loan soon after your employment ends - a time when you may be least able to come up with the money. If you don't repay your loan, it will be considered a withdrawal, which means you’ll have to pay income taxes on it, and if you’re under age 59 ½, a 10% early-withdrawal penalty.

Furthermore, even a relatively small loan could end up costing you thousands of dollars in foregone retirement benefits. That’s because until you repay the loan, the total amount you borrowed isn’t available to continue its tax-deferred compound growth. And if you don’t continue to make new contributions while your loan is outstanding, you’ll lose the significant tax breaks, as well as any matching benefits your employer makes. Plus, the interest you pay yourself may not beat the returns your money could have earned, especially, for example, if you had left it invested in a stock fund. So if you do borrow from your 401(k), make every effort to continue making new contributions. And if you're given the option, designate that your loan money be taken first from any fixed-income investments you have, such as bond or guaranteed-investment contract accounts.

Q: What should I do with the money in my plan if I leave my job?

A: If you leave your employer for any reason, you have four main options for your 401(k) plan money:

• If your balance is more than $3500 ($5000 starting in 1998), and you’re satisfied with the investment options and services, you can leave your account with your former employer. Before you settle on this option, though, find out the rules for former employees’ accounts, such as if you’ll be charged higher administrative fees.

• You may be able to transfer your account to your new employer’s 401(k). If your new employer does in fact accept transfers, new IRS rules allow you to make this move even if you’re not eligible to participate in your new plan right away.

• You can roll over part or all of your account into an IRA. If there’s any chance that you may want to transfer your money later to a new employer’s plan, roll your account into what’s called a Conduit IRA, and don’t make any future contributions to it. That way, you’ll leave your options open by keeping your 401(k) money separate from any other IRA funds.

• Make sure you have your account transferred directly to your IRA custodian. Why? Because if you get the check, you’ll have up to 60 days to reinvest it without penalty, but federal tax law requires your former employer to withhold upfront 20% of the total. That’s because the IRS assumes that because you got the check, you’re planning to cash out. So you’ll have to come up with that 20% out-of-pocket and add it to your IRA, or it will be considered a distribution subject to income taxes, and if you’re under age 59 ½, a 10% early withdrawal penalty. The IRS will eventually refund the withheld 20%, but only after you file your tax return for the year and satisfy them that you have the entire amount, including the 20% withheld, reinvested in your new IRA.

• As a last resort, you can cash out the vested portion of your account. But you’ll lose a significant chunk of your money to income taxes, and if you’re under age 59 ½, a 10% early-withdrawal penalty. Moreover, you’ll lose out on all those future years of tax-deferred growth.