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

Jennifer Post
Jennifer Post
Business News Daily Contributing Writer
Updated Aug 22, 2022

Employees can contribute a portion of their pay to saving for retirement and have the money automatically deducted from their paychecks before taxes.

  • There are five types of 401(k) plans: traditional, safe harbor, SIMPLE, Roth and solo.
  • When choosing a 401(k) plan, consider your business income, your age as well as your employees’ ages, the time frame during which the business will offer the plan, and the budget and resources you have to manage the plan.
  • 401(k) plans have become the dominant means of saving for retirement across most private sector employers, which have largely done away with pension plans in favor of these market-based savings vehicles. 
  • This article is for small business owners exploring the types of 401(k) plans out there and looking to identify the right plan for their company.

Retirement benefits such as 401(k) plans offer advantages to both employers and employees. The right plan can help you attract and retain the top talent you need to grow your business. There are many types of 401(k) plans available, including options for self-employed individuals. Choosing the right plan begins with assessing your company’s needs and researching the available options. 

What is a 401(k) plan?

A 401(k) plan is a benefit offered to employees that allows them 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. Except for Roth 401(k)s, these plans are tax-deferred, which means federal or state taxes aren’t paid on earnings until the money is withdrawn.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.

Employers have the option to offer a 401(k) 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% of contributions up to a certain percentage of the employee’s salary. Eligibility to participate also differs at 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.

“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 of HR, brand and culture 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.”

Did you know?Did you know?: Offering a 401(k) plan benefits small businesses too. Improved employee morale and financial security can significantly reduce employee turnover, for example, and tax credits can reduce a business’s tax liability.

What types of 401(k) plans are there?

You can find a complete breakdown of 401(k) plans on the IRS website, but these are some of the most common types of 401(k) plans you can expect to find during your search.

 

Editor’s note: Looking for an employee retirement plan for your business? Fill out the below questionnaire to have our vendor partners contact you with free information.

Traditional 401(k) plan 

Considered the most flexible of the plans, a traditional 401(k) allows employees to make pretax contributions through payroll deductions. Traditional 401(k) plans are often offered with an employer match program. These contributions are not always vested, meaning that employees do not own the matching contributions until they meet certain provisions.

  • Contribution limits: In 2022, the annual contribution limit is $20,500, with an additional $6,500 “catch-up” for employees aged 50 and older.
  • Employer match: This contribution is not automatically vested, and the amount depends on the employee’s annual contribution and the employer’s own plan.

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. There are three types of safe harbor plan, two of which have employer match provisions. Safe harbor plans are also not subject to the nondiscrimination tests that traditional 401(k) plans must go through.

  • Contribution limits: In 2022, the annual contribution limit is $20,500, with an additional $6,500 “catch-up” for employees aged 50 and older.
  • Employer match: Yes, it is guaranteed vested; the amount depends on the employee’s annual contribution and the employer’s own plan.

SIMPLE 401(k) plan

The Savings Incentive Match Plan for Employees (SIMPLE) 401(k) is best used as a startup retirement savings plan for companies that do not have a plan in place. Only businesses with fewer than 100 employees can offer this plan.

  • Contribution limits: In 2022, the annual contribution limit is $14,000, with an additional $3,000 “catch-up” for employees aged 50 and older.
  • Employer match: Yes, up to 2% nonelective contribution or up to 3% matching contribution.

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.

  • Contribution limits: In 2022, the annual contribution limit is $20,500, with an additional $6,500 “catch-up” for employees aged 50 and older.
  • Employer match: Yes, pretax.

Solo 401(k) plan

A solo 401(k) plan for self-employed individuals or businesses with only one employee offers contractors and sole proprietors a retirement savings option as well. Self-employed individuals can choose the traditional or Roth structure for their solo 401(k) plans.

  • Contribution limits: In 2022, the annual contribution limit is $61,000, with an additional $6,500 “catch-up” for employees aged 50 and older.
  • Employer match: Not applicable.

Profit-sharing plans

With a profit-sharing plan, an employer sets aside a portion of its pretax income to share among its employees. This plan type gives you flexibility in how much money you contribute. There are several varieties of profit-sharing plans under this umbrella, including pro rata plans, new comparability plans and age-weighted profit-sharing plans.

  • Contribution limits: For 2022, the annual contribution limit for profit-sharing plans is $61,000 or 100% of the employee’s salary, whichever amount is lower.
  • Employer match: Yes; the amount varies.

403(b) plans

A 403(b) retirement plan is a tax-sheltered account reserved for teachers that is sometimes also used by eligible not-for-profit organizations, including religious ones. Contributions are pretax, and earnings are not taxed until they are distributed.

  • Contribution limits: In 2022, the annual contribution limit is $20,500, with an additional $6,500 “catch-up” for employees aged 50 and older.
  • Employer match: Yes, pretax.

There are many other types of 401(k) plans, but the more complex they become, according to Meadows, 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.”

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 [the IRA limit] per year.”

Did you know?Did you know?: You can borrow against a 401(k) without incurring tax penalties for early withdrawal, but you will have to pay the borrowed amount back through future contributions.

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):

  • Paying for a 401(k) plan would affect the success of the business if it already doesn’t have enough money to run.
  • The plans are complicated and usually involve a lot of jargon.
  • Plans are expensive. There are fees involved, such as managing fees and investment fees, that aren’t usually presented at the outset.

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

Do you not understand the plan yourself? 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.

If your business offers a 401(k), that 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.”

TipTip: Companies of any size can offer a 401(k) plan. If you’re new to the process, connect with a financial advisor who can help you find the best option for your company.

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

401(k) plans have been 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 people and culture and certified benefits professional at Ascendum Machinery. “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. The money 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 establish something called a Simplified Employee Pension (SEP) IRA, which can also be set up for your business’s employees.

Key TakeawayKey takeaway: 401(k) plans have an employer oversight requirement that allows employees to invest in mutual funds guided by professionals, and at lower fees to boot. Roth IRAs are mostly based on tax-free savings incentives.

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 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. 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.

TipTip: Think about the size of your company and what you can afford in terms of contributions and management fees when exploring the types of 401(k) accounts.

The future of 401(k) plans 

Social Security funds continue to be depleted and workers are increasingly concerned about the future of retirement.

Currently, one quarter of Americans 65 and older receive 90% of their income from Social Security payments. However, the 2021 Social Security Trustees report found that, without any intervention, funds will run out by the mid-2030s. At that time, the report estimates Social Security funds will only pay 78% of scheduled benefits.

Roger Lee, co-founder of Human Interest, agrees that America has a looming retirement crisis. 

Roughly half of Americans 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), these plans 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.

Stella Morrison contributed to the writing and research in this article. Source interviews were conducted for a previous version of this article.

Image Credit:

SARINYAPINNGAM / Getty Images

Jennifer Post
Jennifer Post
Business News Daily Contributing Writer
Jennifer Post is a professional writer with published works focusing on small business topics including marketing, financing, and how-to guides. She has also published articles on business formation, business software, public relations and human resources. Her work has also appeared in Fundera and The Motley Fool.