What is a 401(k) and How Does it Work?

What is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan that helps employees and business owners contribute for retirement. It is named for Section 401, Paragraph K of the U.S. Internal Revenue Service Code that defines “Cash or Deferred Arrangements”. Section 401(k) outlines the rules and guidelines around ERISA (Employee Retirement Income Security Act) employee-sponsored retirement plans such as 401(k)s. 401(k) plans are a popular retirement plan for businesses and employees because they offer flexibility, automatic payroll contributions, high contribution limits, and tax benefits.

How Does a 401(k) Work?

As an employer offering a 401(k) plan, you are responsible for selecting a 401(k) provider to offer 401(k) benefits for eligible employees. Employees, including owners, may elect to contribute to a 401(k) by selecting a percentage or amount to defer from their salary each pay period to add to their retirement plan account. Employees will select which investment or investments from a retirement appropriate fund roster to build their nest egg. For each pay period, the employee’s contribution is placed into investments along with any employer matching contribution. These regular payroll contributions make use of an investing tactic called dollar-cost averaging. The 401(k) contributed money is invested with the goal of growing over time and helping fund each employee’s retirement.

Money added to a traditional 401(k) is contributed pre-tax and isn’t taxed until it is withdrawn in retirement. Many plans also offer a Roth 401(k) feature that allows participants to make after-tax contributions to their plans, and this money is not taxed when withdrawn in retirement. Withdrawals before the age of 59½ may incur a 10% tax penalty. If you are a business owner with employees, you can also offer a match or other contributions to employee accounts. These may be immediately vested or may be part of a vesting schedule based on how you, the employer, decide to provide the match.

If you’re managing 401(k) benefits, you can expect to do an upload with each payroll to your 401(k) plan provider or integrate this with your payroll depending on the payroll provider. Either way, this process typically does not take too much time. You will also need to do an end-of-year checklist so that the form 5500 is completed and any plan testing needs are covered. 5500s are not needed for Solo 401(k) plans until they have more than $250,000 in assets.

What Types of 401(k)s Are There?

There are four core types of 401(k) plans. While 401(k)s offer a lot of flexibility that allow plan sponsors (employers and their administrators) to set up a retirement plan to meet their business needs, these plan designs also help meet required regulatory obligations in providing 401(k) plan benefits.

Solo 401(k)

A Solo 401(k) plan is for self-employed individuals or owner-only businesses without any employees (e.g. two partners own a business but have no other employees). In addition, spouses can be included. Solo 401(k)s allow self-employed individuals to contribute a maximum amount of $66,000 each year (or $73,500 if aged 50 or older), which is much higher than an IRA, which only allows $6,500 to be saved each year. The Solo 401(k) user may contribute as either an employee, the employer, or both. As an employee, the owner may contribute up to the $22,500 maximum ($30,000 if aged 50 or older). By making employer contributions, an owner can put an additional $66,000 ($73,500 if aged 50 or older) into their 401(k). It’s important to note that the employer contributions must be deferred on a pre-tax basis, however employee contributions can be made pre-tax, post-tax or both.

Those who contribute substantially to a Solo 401(k) may benefit from some tax advantages such as lower personal taxes which potentially moves them into a lower tax bracket. Business owners can put a portion of their salary away tax-deferred or in a Roth 401(k). Unlike a Roth IRA, Roth 401(k)s have no income cap to make a contribution. By contributing tax-deferred, personal taxes are lowered in the current year, but will be due when withdrawn in retirement at the tax rate at that time. If using Roth, contributions are made after-tax now, and then withdraw tax-free in retirement, earnings and all.

Safe Harbor 401(k)

A Safe Harbor 401(k) helps maximize employee savings and simplifies plan management for a business. Safe Harbor 401(k) plans automatically satisfy the requirements of IRS non-discrimination testing avoiding these testing responsibilities and hassles. By providing a “Safe Harbor” immediately vesting matching contribution to all participating employees (including the owner), employers guarantee that all employees will be able to contribute up to the maximum amount to their accounts if they choose (for 2023, the maximum contribution is $22,500, or $30,000 if age 50 or older). Most employers choose to provide a Safe Harbor match of either 3% or 4% of salary, and these contributions are tax deductible for the business. In fact, if this is the company’s first 401(k) plan and it has under 50 employees, tax credits will also be applied towards matching over the first three years of the plan. These tax deductions and tax credits are available to any qualifying small business starting a 401(k) plan no matter the plan type except for a Solo 401(k) Plan.

Traditional 401(k)

A Traditional 401(k) plan offers added flexibility in plan features. Businesses can choose whether or not to offer 401(k) matching. Employers that choose to match are also able to establish vesting and/or eligibility rules to retain and reward loyal associates. Traditional plans can be a smart option for businesses that have highly seasonal cash flows and/or labor, experience relatively high employee turnover, or need the flexibility to leverage a different match amount than a Safe Harbor would require.

The ability to add multi-year vesting schedules can also make these plans a valuable tool for employee retention, especially in high turnover industries. In addition, eligibility rules can simplify administration and plan costs for businesses that have seasonal work forces. Employees with a Traditional 401(k) plan can contribute the same maximum amount per year as a Safe Harbor 401(k) ($22,500 for 2023, or $30,000 if age 50 or older). Satisfying the requirements of plan testing can be more problematic if deferral rates of staff is significantly lower than management. It may also restrict how much highly compensated employees may contribute in the year to an amount well below the $22,500 limit. Leveraging autoenrollment with a high deferral rate of 5% or higher and other tactics can help minimize these issues.

Tiered Profit Sharing

Tiered Profit Sharing (also known as Advanced Profit Sharing) enables a company to identify unique groups in an organization and reward employees a different share of profits by group. For example, a manufacturing company may have employees in management, sales, and production. Each can receive a different payout structure of profits as part of their 401(k). This can be a beneficial way to align goals and compensation by each group’s contributions to the company’s success.

401(k) plans are regulated to benefit all participating employees as fairly and equally as possible. Typically, in a standard profit sharing method, employer contributions, or a match, are the same percentage for all participants. The Tiered Profit Sharing design can be a cost-effective way to provide contributions that are different percentages or amounts to employees. To pass 401(k) IRS tests, a Tiered Profit Sharing plan may require Safe Harbor contributions or other arrangements.

Many companies use 401(k) profit sharing plans for the simple reason that employer profit sharing contributions placed into a 401(k) plan are tax-deductible for the firm.

Roth 401(k) Feature

As mentioned in the Solo 401(k) section, a Roth 401(k) is a feature that allows a participant to make after-tax contributions to her or his 401(k) account, up to the current employee contribution limits ($22,500 in 2023, $30,000 for those 50 or older). Once in retirement, these funds aren’t taxed—even the earnings—during withdrawal. Unlike a Roth IRA, there is no income limit for contributing to a Roth 401(k). Plan sponsors can choose to provide a Roth option for their employees and employees can choose to contribute all, some, or none towards the Roth. Tax-deferred contributions and Roth 401(k) contributions in total may not exceed the 401(k) contributions limits in any given year.

For you, as an individual deciding whether to put funds into a regular 401(k) or Roth 401(k), it’s important to consider what tax rates you are experiencing now and where you might expect them to be in retirement. Contributing tax-deferred to your 401(k) will net you more tax savings in the current year, as these contributions reduce your current adjusted gross income. You also do not pay taxes on the contributions until they are withdrawn for retirement. However, both contributions and earnings are taxed when withdrawn. Roth 401(k) contributions are made after-tax at the time of the contribution. Since the government has already collected taxes on these monies, even though they are expected to grow as you build for retirement, the government doesn’t tax you again when you withdraw them in retirement, earnings and all. Depending on your tax rate now versus in retirement, this may save you more money in the long run. Remember, these contributions have no effect on your current adjusted gross income, so you will receive no benefit once it is time to file your taxes in the year they are contributed.

The bottom line for determining if you want or contribute pre or post taxes to your 401(k) is whether you want to pay taxes now or later. If you prefer to pay taxes now or think your tax rate will be higher in retirement, choosing to contribute to the Roth 401(k) will likely be the way to go. If you want to pay taxes later, need to reduce your taxable income this year, or want less of a hit to your current paycheck, choose the tax-deferred 401(k) option (historically the most common, but that may be changing). You can also choose to allocate a percentage of your salary to both. That way, you can receive some of the benefits of both retirement account types and diversify your tax management strategy for retirement.

Which 401(k) Plan is Best for Your Business?

To determine which 401(k) is best for your business, it is a good idea to go through the different plan designs and compare them to the needs of your business. If you are a self-employed business owner, your best option is a Solo 401(k) if you feel like you will contribute more than $6,500 a year to retirement. Otherwise, an IRA is a good place to start.

If your business has employees, it is important to consider whether you want to offer a 401(k) match, if you want to adjust vesting schedules or employee eligibility, or if you need to segment your employees and reward them differently with employer contributions based on meeting specific requirements. Whatever the case may be, there is no better time than now to consider your needs and your business’s needs when it comes to benefits, taxes, and preparing for retirement.

Key Takeaways:

1. A 401(k) is an employer-sponsored retirement savings plan that helps employees and business owners contribute for retirement. Employees contribute a select percentage or dollar amount to the 401(k), which is then invested.
2. Employers have some options when determining which 401(k) is right for their business. Typically, the choice depends on the size of the business and level of flexibility needed for the retirement plan offerings.
3. Self-employed business owners have the option of choosing a Solo 401(k) to maximize their retirement savings. Business owners with employees can consider a Safe Harbor 401(k), Traditional 401(k), or Tiered Profit Sharing 401(k) for their retirement needs.
4. Business owners can elect to include a Roth 401(k) option as part of their 401(k) plan benefits. This allows their participants to choose if they want to contribute to their 401(k) post-tax via Roth 401(k) or pre-tax via traditional 401(k).