Updated: Dec 6, 2021
What is a 401(K) plan?
A 401(k) is an employer-sponsored retirement savings plan allowing employees to invest a portion of their salaries for their retirement. Upon the enactment of the Employee Retirement Security Act of 1974, conventional pension plans gained tightened regulatory oversight. This resulted in the rise of 401(k) plans being a more economical option.
In this type of plan, the elective deferrals are not considered taxable income on one's Form 1040, U.S. Individual Income Tax Return, and are exempted from federal income tax withholding. However, according to Publication 525 of the Department of Treasury, they still encompass federal unemployment taxes (FUTA), Social Security (FICA), and Medicare.
Why is 401k important?
This type of plan offers tax advantages that serve both the employee and employers.
Employees enjoy the benefits it offers, such as the tax-deferred earnings. Workers need not pay taxes on dividends, capital gains, and contributions allowing the money to flourish until withdrawal. Moreover, this type of plan allows for compound interest. Meaning, if one starts saving money at an early stage, the investment earnings or interests accumulate over time, leading to massive monetary growth later down the road. Also, the payroll deduction's efficiency helps employees lessen their cognitive load as the payment scheme is done automatically. A 401(k) account's portability is also an enticing benefit as it allows a smooth transition to a new employer's retirement plan (if they plan to leave the company) or a personal IRA plan upon withdrawal. Furthermore, help in balancing out the initial $2,000 contribution to this plan is possible. This may be availed by low-income and moderate-income employees through a Saver's Credit.
When the contributions from the employees' accounts are transacted for business owners, they become entitled to tax deductions for contributions to the plan. This allows employers to motivate, maintain, and captivate promising employees.
What are the 401(k) plan types?
There are different plan types to choose from:
A traditional 401(k) plan is subject to annual nondiscrimination testing, which ensures that most employees' benefits are proportional to highly compensated employees and owners. This is due to the provision that employers can contribute to all participating employees and/or to match their deferrals.
In contrast, a safe harbor 401(k) plan does not have the annual nondiscrimination testing, but features are similar to a traditional 401(k) plan. There is a certain amount of annual employer contribution in this kind of plan.
A solo 401(k) plan has features comparable to a traditional 401(k) plan, such as pre-tax and Roth contributions, but made for solo or family-owned businesses. It has a loan feature that allows for access to balances gathered over time while providing maximum allowable contributions.
How do 401(k) contributions work?
Employees and employers are both allowed to contribute to this plan although, there are differences in the permitted contributions.
An employee may contribute through a Regular Deferral entailing a pre-tax contribution, which is deductible upon the enactment of the plan. Once the current income tax rate is established, the balance accumulated will be taxed.
On the contrary, a Roth Deferral is an after-tax contribution by employees that is not deductible upon the plan's enactment. As long as the contributions made are not in the plan for the last five years, at least, contributions will grow free of tax, and the accumulated balance will not be taxed upon distribution.
For older workers nearing retirement age, a Catch-Up Contribution may be a considerable option allowing additional contributions to be deferred to their 401(k) accounts.
Employers also have contribution options such as a Fixed Company Match. This option is common for small enterprise owners as it entails a fixed rate in matching employees' contributions.
Another option is a Discretionary Company Match, which provides flexibility and freedom to employers. They may opt to offer an increase or decrease in the proportion of each employee's deferral.
A Discretionary Profit Sharing is usually for employees that rarely contribute to their own account. This includes employers to give a one-time or periodic contribution.