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What Is a 401(k) Plan and How Does It Work?

Employee Consulting About 401(k)

Among the most popular employee benefits that appeals to both job candidates and employees is a 401(k) plan. This unique savings account allows participants to contribute a portion of their wages on a pre-tax basis, and it offers several other benefits that can help build savings for the future.

What is a 401(k) plan?

A 401(k) plan is a specific type of retirement savings account that is regulated by the IRS. Individuals are allowed to contribute up to a specified amount each year, and all funds in a 401(k) plan are eligible for tax benefits. Many 401(k) plans are administered through a sponsoring employer, allowing employees to contribute funds to their plans on a pre-tax basis. This makes it simple for many employees to save for retirement.

Are there different types of 401(k)s?

401(k) plans refer to any plan governed by subsection 401(k) of the Internal Revenue Code. While these plans all have similar requirements and limitations, the IRS code does have flexibility for different types of 401(k) plans.

Individuals can receive tax savings from several types of these retirement plans, including:

  • Traditional 401(k): The traditional version of a 401(k) plan can be offered by employers of all sizes and has some flexibility in how much both employees and employers contribute to the plan, up to the limitations set by the IRS Code.
  • Roth 401(k): This plan combines the features of a Roth IRA and traditional 401(k), allowing employees the option of contributing after-tax dollars to the plan, thus avoiding later taxation.
  • Solo 401(k): Often referred to as a "self-employed 401(k)," this plan is specifically designed for employers who have no full-time employees other than the business owner and spouse.
  • Safe Harbor 401(k): Typically offered to highly compensated employees who own a percentage of the company, this plan stipulates that employer contributions are fully vested immediately upon contribution, therefore avoiding many of the annual compliance tests required by other 401(k) plans.
  • Simple 401(k): To qualify for this plan, the sponsoring employer must have 100 or fewer employees and not have any other retirement plans offered. Simple 401(k)s restrict the employer to certain contribution and filing requirements.
  • Profit-sharing: This unique plan allows employers to contribute on behalf of the employee based on the profits of the company; only the employer can make contributions to this plan. Employee elective contributions are not allowed.
  • 403(b): These plans are similar to 401(k) plans, but can only be offered to employees of nonprofit organizations or certain government employers.

How does a 401(k) work?

Traditionally, 401(k) plans are set up through an employer in association with other benefit options. When employees become benefits-eligible, some plans utilize an auto enrollment feature, or they will sign up for the plan and set their designated 401(k) contributions as part of the benefits enrollment process. Self-employed individuals can also enroll in a solo 401(k) through a qualified broker.

Once the plan is initiated, the employee's designated contribution amounts are processed through payroll deduction on a pre-tax (or post-tax for a Roth 401(k)) basis. The employer will take the payroll deduction amount and any employer match contributions and deposit the funds into the employee's designated account.

After the contributions are made, employees typically have access to an online portal where they can track the account value and performance over time, choose designated investment percentages (if offered through the employer's plan), or borrow money against the value in the account.

Rules of a 401(k): withdrawals and transfers

Since 401(k)s are designed to be a long-term savings vehicle for retirement, withdrawing or transferring money in and out of the account isn't a simple process. Most withdrawals from individuals below age 59 ½ will incur an early withdrawal penalty, and there are also tax implications to consider. In most cases, the money was initially contributed to the account before taxes, so the distribution is taxable, and the individual will incur an additional penalty from the IRS once they've withdrawn funds.

Fortunately, you can make a penalty-free 401(k) withdrawal if:

  • You are taking a qualified disaster distribution of less than $100,000 due to certain  FEMA-declared disasters You are withdrawing from a tax-deferred account and are a named beneficiary, a qualified reservist, permanently disabled, or have reached age 59 ½; or
  • You are withdrawing from a Roth account that has been open for at least 5 tax years and are a named beneficiary, a qualified, reservist, permanently disabled, or have reached age 59 ½.

In some cases, you may want to transfer money out of an existing 401(k), such as when you change jobs to a new employer.  A cash-out of the account will typically result in penalties and taxes, but transferring to another 401(k) account or performing a 401(k) rollover can help you avoid those deductions.

While you can't transfer funds from a 401(k) account to your personal savings account penalty-free, you can avoid most penalties by transferring the funds to another qualified retirement account, such as an IRA.

Rules of a 401(k): contributions and limits

The IRS regulations that govern 401(k) plans also specify how much an individual can contribute to a plan per year. These restrictions are designed to prevent abuse of these plans by highly compensated employees and encourage early retirement planning. These contribution limits are adjusted periodically for inflation, and updated numbers are published on the IRS website.

The 401(k) contribution limits for 2021 are:

  • $13,500 per year in elective deferrals for a SIMPLE 401(k)
  • $19,500 per year in elective deferrals for traditional 401(k) and safe harbor plans
  • $3,000 per year in catch-up contributions for a SIMPLE 401(k) if the employee contributing to the plan is age 50 or older
  • $6,500 per year in catch-up contributions for traditional 401(k) and safe harbor plans if the employee contributing to the plan is age 50 or older
  • $58,000 per year in total contributions (employee elective deferrals and employer contributions combined)
  • $64,500 per year in total contributions (employee elective deferrals plus catch-up contributions and employer contributions) for employees age 50 and older

Employers can elect to match employee contributions as an additional employee benefit, but this is not required, and any employer match is subject to the total contribution limits listed above.

Nondiscrimination requirements

When employers offer 401(k) plans to employees, those plans are subject to obligations and tests from the IRS to ensure the plan is complying with the tax code. These obligations and tests are designed to ensure that owners and partial owners — often referred to as "highly compensated employees" — cannot use 401(k) plans as a way to shelter company profits or otherwise unfairly benefit compared to non-key employees.

A traditional plan must comply with:

  • Average Deferral Percentage ("ADP") test: This test compares the deferrals of highly compensated versus non-highly compensated employees.
  • Average Contribution Percentage ("ACP") test: This test compares employer matching contributions and employee after-tax contributions for highly compensated versus non-highly compensated employees.
  • Top-Heavy Test: This test evaluates the overall benefits in the plan for key employees such as owners and officers compared to benefits received by non-key employees.

Pros and cons of a 401(k) plan

Creating a savings plan is an important part of preparing for retirement. Like any savings tool, there are pros and cons to using a 401(k). For many employees, 401(k)s are one of the best retirement planning vehicles for maximizing savings but investing in general involves some amount of risk.

Before investing in a 401(k), you should be aware of the most common pros and cons associated with this type of retirement savings plan.

Pros

  • Employers can match contributions (although it is not required), essentially giving employees free money.
  • Employers also can make a profit-sharing contribution that is not tied to employee deferrals
  • All plans must meet strict legal standards designed to protect your money and your interests.
  • You may be able to borrow against funds in your account in the event of a financial emergency instead of paying interest to a bank or other financial institution.
  • Most plans allow you to defer income taxes until the funds are withdrawn.

Cons

  • You may have limited investment options.
  • You will typically be charged additional penalties to access your money before age 59 ½.
  • Since money typically goes in tax-free, you must pay taxes even once you reach retirement age, which could be when you need your money the most.

Getting started with a 401(k)

When saving for your retirement, employers may need some guidance, such as deciding between a Simple IRA vs 401(k) plan. For employees, the enrollment process may vary within different organizations, and different companies may also have different waiting periods for new hires before they are eligible to participate.

Eligible employees are required to receive a summary plan document which provides information about their plan  and its available options. If they're not sure how much to save each paycheck, provide them resources such as a 401(k) calculator to help them estimate both expected contributions and  account earnings over time.

Conclusion

For many individuals, 401(k)s are a simple way to begin saving for retirement with a tool that can help their money work harder These retirement plans offer numerous benefits in the form of tax deferred savings and investment options for future income potential. Although there are some considerations with investing, a well-informed employee can use this as a smart way to build a healthy nest-egg for the future.

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* This content is for educational purposes only, is not intended to provide specific legal advice, and should not be used as a substitute for the legal advice of a qualified attorney or other professional. The information may not reflect the most current legal developments, may be changed without notice and is not guaranteed to be complete, correct, or up-to-date.

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