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401(k) Plan: What It Is and How to Choose One

Jennifer Post
Jennifer Post

A 401(k) is a profit-sharing plan for employees to contribute savings for retirement.

  • A 401(k) is a retirement plan that allows employees to contribute wages to an individual account via automatic deductions from their paychecks.
  • There are four types of 401(k) plans: traditional, Safe Harbor, SIMPLE and Roth.
  • Many small businesses wrongly think a 401(k) is only for big businesses.
  • A traditional 401(k) defers taxes until funds are withdrawn. With a Roth 401(k), you pay taxes upfront. Mutual funds allow employees to invest in a collection of stocks, bonds or both, but this isn't necessarily a retirement fund.
  • When choosing a 401(k), consider your income, the ages of your employer and fellow employees, the time frame for which the business will offer the plan, as well as the budget and resources that are available to manage the plan.

A 401(k) is part of a profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts to save money for retirement. The money is deducted from their paycheck and deposited directly into their 401(k) account. With the exception of a Roth 401(k), these plans are tax-deferred, which means federal or state taxes aren't paid on earnings until the money is withdrawn.

Because the contributions don't count toward the employee's taxable income, the Internal Revenue Service (IRS) sets limits on how much employees can contribute to a 401(k) plan each year. The limit for employee contributions has increased from $18,500 in 2018 to $19,000 for 2019, but it could be adjusted again in the future depending on the cost of living.

Employers have the option to match or make their own contributions to their employees' 401(k) plans as an enticement for them to participate. The amount will vary by company, but the company may offer to match between 25% and 100%, up to a certain percentage of the employee's salary. The eligibility to participate also differs with each company, with some allowing employees to start contributing to a plan as soon as they are hired, and others requiring a waiting period of one month to a year.

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"While MEPs (multiple employer plans) and state mandates are all the talk on an industry level, the 401(k) is still the best tried-and-true way to save at work," said Andrew Meadows, senior vice president at Ubiquity Retirement + Savings. "With high contribution limits and the ability to lower costs, the 401(k) is becoming leaner and a more popular option for small businesses."

What kinds of 401(k) plans are there?

A complete breakdown of 401(k) plans can be found on the IRS website, but these are the four most common types:

  1. Traditional 401(k) plan. This is considered the most flexible of the plans and allows employees to make pretax contributions through payroll deductions.

  2. Safe Harbor 401(k) plan. This plan is similar to the traditional plan, except it mandates that employer contributions be vested as soon as they are made.

  3. SIMPLE 401(k) plan. Only businesses with fewer than 100 employees can offer this plan.

  4. Roth 401(k) plan. This plan is funded with post-tax income, so money saved is not subject to any federal or state taxes as long as the investor reaches the age of 59.5 before withdrawal.

There are many other types of 401(k) plans, but according to Meadows, the more complex they get, the less likely they are to fit small businesses.

"Larger companies with a 401(k) may want a special variety for their type of business," he said. "However, small businesses will likely want to keep it simple to avoid any complicated compliance worries." [Interested in employee retirement plans? Check out our reviews and best picks.]

He also noted that it's important to know why the plan is being established in order to determine which one is right for your business. "Is this a plan for the owner to put as much money as possible away for their own future, or is this primarily a benefit for employees? Without a doubt, this is a great decision for any company that expects to put away more than $6,000 per year – the 2019 limit for an IRA."

Is a 401(k) plan right for your business?

You may think your business is too small for a 401(k) plan, but these plans aren't only for big companies. Meadows noted that this is a common misconception, saying small business owners have a few main reasons for being hesitant about implementing a 401(k):

  • Having a 401(k) plan would affect the success of the business if they already don't have enough money to run the business.
  • The plans are complicated and usually involve a lot of jargon.
  • It is expensive. There are fees involved, such as managing fees and investment fees, that aren't usually presented at first.

While the IRS website tells you exactly what you need to know about the plans, your employees might not have any idea what it actually means. Meadows advised employers to use plain language when explaining the plan to your employees.

Don't understand the plan yourself? Or do you have questions about your contributions as an employer? Consider hiring a financial advisor with plenty of experience in the industry, Meadows said.

"The best financial advisors are the people who have already done it," he added.

Your business offering a 401(k) can mean a lot for the talent you have – and the talent you want.

"One benefit for even the smallest businesses to have a 401(k) plan for employees is simply to attract and retain talent," said Ben Smith, founder and certified financial planner at Cove Financial Planning. "Many job seekers and current employees will value the added benefit of having access to a retirement plan offered by their employer, and they may look elsewhere for work if a business does not offer one."

What's the difference between a 401(k), a mutual fund and a Roth IRA?

A 401(k) plan has been pretty thoroughly explained, but mutual funds and Roth IRAs tend to elude people. Are they similar? Should you choose one of those over a 401(k)? Here's the difference.

"401(k)s contain mutual funds, but the fees for those funds are lower than an individual could purchase on their own," said Cynthia Keaton, vice president of HR and certified benefits professional at Thorne. "There is a requirement for company oversight, so there is a constant review of the funds to ensure they are the best options for employees. An individual who selects their own [mutual] funds does not have the advantage of this expertise monitoring the funds, and a financial planner may have an incentive to keep individuals in higher-fee funds."

Meadows defines a mutual fund as "the investments your pre- or post-tax dollars go into so that they can grow into a valuable nest egg for your retirement."

Roth IRAs, on the other hand, are individual retirement accounts that have more differences than similarities to a 401(k) plan. If you're an employee with an IRA, your employer can contribute a discretionary amount of post-tax money. This basically means that, for the year contributed, there is no tax deduction. It also grows tax-free, and a Roth IRA isn't tied to an employer.

"This means that when the owner pulls money out in future years, it comes out tax-free," said Smith. This part of a Roth IRA is very similar to a Roth 401(k).

If you're a business owner, you can set up something called a Simplified Employee Pension (SEP) IRA, which can also be set up for your business's employees.

What should you consider when choosing a plan, and when should you get one?

Meadows said that small businesses should want to provide the most robust 401(k) plan that the business can afford.

"Today, there are more and more providers helping small businesses avoid high-cost funds and access manageable monthly administration fees," he continued. "This may vary from business to business, but the sooner you can set up a 401(k) plan, the better."

Even though having a 401(k) plan makes the most sense for small businesses, there are many things to consider as a business owner when considering offering your employees a retirement plan such as a 401(k). Here are a few that Smith laid out:

  • Income and age of owner(s)
  • Income and age of the employees
  • The time frame for which business will offer the plan
  • The budget and resources that are available to manage the retirement plan

"Generally speaking, any business that seeks to provide a relatively simple and low-cost plan may consider a 401(k)," Smith said.

What's on the horizon?

The future of retirement is never certain. Many members of the millennial generation doubt that Social Security is even going to be a thing when they are at retirement age. But that's why 401(k) plans and other retirement plans are important. If you start early enough, they will be there for you when the other programs won't be.

Roger Lee, CEO of Human Interest, agrees that America has a looming retirement crisis.

"A recent Bankrate survey found that 1 in 5 working Americans aren't saving any money for retirement," he said. "What's more, roughly half are saving 10% of their annual income or less toward all of their financial goals, falling short of what is recommended for retirement. While it's essential to have a discussion about financial responsibility and planning, it's also important to recognize that many workers don't have access to 401(k) plans, which has become the dominant means of saving for retirement."

However, if you are one of the lucky people who have access to a 401(k) plan, they have become the forerunner in addressing retirement needs.

"[Social Security] and pension plans are of the past," said Brian Menickella, co-founder of financial services firm The Beacon Group of Companies. He thinks the financial future of retirement is bright, even with the continued concern around Social Security.

Image Credit: juststock / Getty Images
Jennifer Post
Jennifer Post,
Business News Daily Writer
Jennifer Post graduated from Rowan University in 2012 with a bachelor's degree in journalism. Having worked in the food industry, print and online journalism, and marketing, she is now a freelance contributor for Business News Daily and business.com. When she's not working, you will find her exploring her current town of Cape May, New Jersey, or binge-watching "Pretty Little Liars" for the 700th time.