What you need to know about a 401(k)

What is a 401(k) plan?

A 401(k) plan is a qualified plan offered by an employer that allows employees to have a portion of their wages deferred directly from their paychecks into a retirement account. Contributions are generally made pretax and they can be placed into a variety of 401(k) investments. Once invested, any investment growth in the 401(k) is tax-deferred.

A 401(k) vs. a pension plan

401(k) plans and pension plans are both employer-sponsored retirement plans. A pension plan is a defined-benefit plan that provides a specified payment amount in retirement. In a pension plan, employees don’t have control over the investment decisions.

In contrast, a 401(k) is a defined-contribution plan, which specifies the amount of the contribution going into the plan, but not the future benefit. In particular, a 401(k) allows both employees and employers to contribute and gives employees the ability to choose their own 401(k) investments.

A 401(k) vs. a SEP IRA

SEP IRAs are also employer-sponsored retirement plans. Both SEP IRAs and 401(k) plans give employees the power to select investments.

In a SEP IRA, contributions are only made by the employer. They can be made at any point up until the employer’s taxes are filed for the year in question. Employers can decide each year how much they’d like to contribute, or decide not to contribute at all.

Contrast this with a 401(k), where employees primarily make the contributions, but employers can also choose to contribute retirement funds to their employees’ accounts.

See our side-by-side comparison of SEP IRA vs. 401(k).

401(k) vs. a traditional or Roth IRA

The main differences between a traditional or Roth IRA (individual retirement account) and a 401(k) plan involve contribution limits and responsibility. As the name implies, a traditional or Roth IRA is a retirement account for individuals rather than a plan maintained by an employer. For these IRAs, annual contributions max out at $6,000, with an additional $1,000 catch-up contribution for individuals over the age of 50¹.

That is significantly less than the contribution maximums for a 401(k) plan. Another big difference is that, although employers can help individuals set up an account, they are not allowed to contribute to an employee’s traditional or Roth IRA.

401(k) benefits for employers

1. Attracting talent

When you’re competing with other employers for high-quality job candidates, having a 401(k) benefits the employer, and not just the employee. It lets potential employees know you’re interested in investing in their futures on a long-term basis.

And with only 67% of private industry workers having access to employer-provided retirement plans, not having a competitive retirement offering in place may cause top talent to look elsewhere.

2. Encouraging employee retention

According to the U.S. Bureau of Labor Statistics, the median number of years an employee spends at a job is 4.1. When you narrow the demographic to workers in the age range of 25-34, the median number of years spent at an employer shrinks to 2.8.

Employees seeing their 401(k) investments increase year after year through their own contributions and (where applicable) company matches can make your employees feel like you are not only providing for their present needs and expenses, but also facilitating their lives after retirement.

3. Tax benefits

401(k) plans offer a variety of tax benefits to employers. Employer contributions can generally be taken as a tax deduction, but there are limitations on this. Employers may also be able to deduct plan administrative expenses.

There are also tax credit opportunities for employers starting a new plan. If you’re starting a 401(k), you may be eligible to receive up to $16,500 in tax credits over the plans’ first three years to help offset initial plan costs.² This credit is available if you meet the following qualifications:

• Your company has 100 or fewer employees who earned $5,000 or more in the preceding year.
• Your plan group must include at least one participant who is not a highly compensated employee.
• In the three years before the creation of the new 401(k) plan, your employees cannot have been covered by another plan sponsored by you.

What is the difference between a traditional and Roth 401(k) plan?

Traditional 401(k)

Traditional 401(k) plans allow employees to contribute funds to the plan on a pre-tax basis, meaning their contributions lower their adjusted gross income. The funds and their growth are later taxed upon withdrawal. The tax rate is a bit of a risk, as it is nearly impossible to predict what tax rates will be in the future when the funds are withdrawn.

Funds can be withdrawn without penalty on or after attaining the age of 59½. Required minimum distributions begin at age 72 if the employee’s 70th birthday is July 1, 2019 or later. If their 70th birthday was before this date, required minimum distributions must begin at age 70½.

Roth 401(k)

A Roth 401(k) plan feature is relatively new in the world of retirement plans. They were first introduced in 2006 in an attempt to combine the best qualities of Roth IRAs and traditional 401(k) plans.

However, they have become increasingly popular, with three-quarters of businesses with retirement plans offering this feature. Unlike a Roth IRA, there are no income limits that govern who is eligible to contribute.

The main difference between a traditional 401(k) and a Roth 401(k) is when the contributions are taxed. With a Roth 401(k), employee contributions are taxed before being sent to the retirement account. The growth on contributions is also taxed deferred, and the main benefit is qualified withdrawals are not taxed when made. (Note that any employer matches or profit-sharing contributions cannot be made on a Roth basis as they are not employee deferrals - these will be tax deductible to the employer, grow tax deferred, and be taxed upon withdrawal.)

There are also distribution differences. Funds can be withdrawn from a Roth account without penalty at or after age 59½, but there is an additional requirement that the employee needs to have held the Roth 401(k) account for at least five years.

For example, if an employee first makes a Roth contribution at age 57, any Roth 401(k) funds will not be accessible without incurring a penalty until the employee reaches age 62, since the normal withdrawal age of 59½ is less than the five-year holding period.

Steps for setting up a 401(k) for your business

1. Consider types of 401(k) plans

There are many types of 401(k) plans available for business owners. All varieties have different advantages and limitations. 401(k) providers should be able to direct you toward the most beneficial types of 401(k) plans based upon a few factors. They typically look at things including number of employees and if you plan to make employer contributions. Here, we’ll focus on traditional and Roth and safe harbor 401(k) plans.

2. Look at 401(k) investment options

There are several investment options available in 401(k) plans, but mutual funds are the most popular. It is important to not only investigate the performance history of the funds, but also how many choices you want to offer within the plan.

Employees can be overwhelmed with the fund selection process if, say, 25 options are presented during participant onboarding. Most 401(k) plans keep the number of investment options somewhere between 8 and 12.

3. Compare investment fees

401(k) plan fees typically come in three forms: investment fees, administration fees and individual services fees. Traditionally, fees for larger plans have been lower per participant than those for plans with fewer participants, effectively giving a volume discount.

4. Review yearly

Assessing your 401(k) plan’s performance on an annual basis is highly recommended. Things to examine include, but are not limited to, investment growth, fees, and employee satisfaction with the plan. Typically, you should compare the long term performance of the funds in your plan with the performance of the fund category’s industry benchmark.  

If anything seems unusual or out of line with expectations, you can contact your 401(k) provider and should consider consulting a qualified tax and financial advisor.

401(k) rules

401(k) contribution limits in 2022

For 2022, the maximum amount employees can contribute to a 401(k) is $20,500. If the employee is age 50 or older, they are allowed an additional $6,500 catch-up contribution, which brings their total annual contribution limit to $26,000.

For 2022, the limit for all combined employee and employer contributions in a plan year is $61,000 (excluding catch-up contributions).

Safe Harbor 401(k)

A Safe Harbor 401(k) plan is very similar to a standard 401(k) plan, but it has a few features that minimize some of the nondiscrimination testing risks and administrative hassle. The main differentiator is that the employer provides a designated match or nonelective amount to the employees, which is immediately fully vested. The Safe Harbor contribution can either be a percentage match available only to employees who defer, or it can be given to all employees, regardless of deferment elections.

By taking these steps, the plan will automatically satisfy most IRS nondiscrimination tests and help avoid the consequences of failure. And while the Safe Harbor contribution is fully vested upon contribution, the employer is still allowed to make additional profit-sharing contributions that follow a vesting schedule.

How do employer 401(k) matching contributions work?

How much should employees contribute to a 401(k)?

While 401(k) contribution recommendations vary among experts, the general suggested range, according to some sources, is 10%-15% of an employee’s gross annual income. This includes a combination of employee contributions and employer matches.

At the very least, employees should consider contributing enough to maximize employer matching if any is available. Failing to do so is essentially “throwing away money.”

401(k) matching contributions and vesting

Matching contributions vary wildly across employers’ 401(k) plans, but commonly range between 3% and 6%.

Deferrals can be matched fully or partially; there can even be a mix of both. Some employers will fully match the first 3% of employee deferrals and then offer an additional 50% match of additional deferrals up to a certain limit (usually capped at 5%). If a plan is set up like this, an employee would have to defer 5% to get the full match of 4% total (3% matched fully and 2% matched at 50%).

To incentivize long-term employment, you can set up your 401(k) plan to allow for all employer contributions (with the exception of Safe Harbor contributions, if applicable) to follow a vesting schedule. A vesting schedule typically ranges from one to six years and is a timeline of when an employee has full ownership of employer contributions. This can incentivize employees to stay with you for longer in order to increase their retirement balance.

Vesting schedules can be graded to slowly increase the vesting percentage over an employee’s years of employment, or they can go from 0% vesting to 100% after a “cliff” of a designated number of years.

While there are many variances allowed in vesting schedules, a typical six-year graded vesting schedule might be as follows:

Choosing 401(k) providers

What to look for in 401(k) providers

401(k) providers should have two main goals: to administer your plan effectively and make the process as hassle-free as possible for you. An effective provider should be able to ask you the questions necessary to set the rules for a 401(k) plan that will benefit you and your employees most.

After a plan is set up, the 401(k) providers can deliver ongoing services to assist in the successful continuation of your 401(k) plan. These services may include, but are not limited to:

• recordkeeping
• employee onboarding
• investment management
• annual 5500 tax return preparation
• creation and distribution of notices
• customer service support for both you and your employees

What tech you want from 401(k) providers

When it comes to technology offered by your provider, the key factor is accessibility. Employers should have the ability to check their plan status at any time via an online portal. Employees also appreciate having their individual account balances available at their convenience, so a portal with separate employer/employee logins has become a very desirable feature.

The ability to integrate various HR and accounting programs with your provider is another key factor as it can be a huge time saver. Without integration, employers and payroll companies may need to submit reports and transactions manually to their 401(k) provider. They do this for recordkeeping and contribution amount designations.

With integration, payroll information is linked from your payroll processor, and any changes or transactions are automatically updated with your 401(k) provider. For example, at Guideline we integrate with many leading payroll providers programs, including Gusto, QuickBooks Online, and Square.

Interested in what Guideline can do for you? Let’s get started.

The information herein is solely for informational purposes only and is not intended to be construed as tax or investment advice. You should consult a professional investment and tax advisor to determine the strategy that fits your specific needs.

¹ Subject to IRS annual limits

² This content is for informational purposes only and is not intended to be construed as tax advice. You should consult a tax professional to determine what types of tax credits or deductions your company is eligible to claim.