401(k) Plan Basics
In Part 3 of this series, we looked at the various types of 401(k) plans. Now let’s step back and look at what all types of 401(k) plans have in common.
A 401(k) plan allows employees to make contributions to a retirement plan from their pay. This is called a 401(k) deferral because instead of receiving all of their pay, the employee directs the employer to deposit a portion of their pay in the retirement plan.
Saving in this way helps the employee accumulate funds they will need at retirement, and it is an easy retirement plan for a business to implement.
Key Things to Know About 401(k) Plans
- 👍 Provides employees the ability to save more than allowed in an IRA ($22,500 vs $6,500)
- 👍 Allows additional savings if an employee is at least age 50 ($7,500 vs $1,000 in IRA)
- 👍 Employees can decide how their deferrals should be treated for tax purposes (pre-tax basis or after-tax basis).
- 👍 After-tax deferrals are called Roth deferrals and have unique tax status.
- 👍 Company is not required to make contributions to its employees, but can if desired
- 👍 Employer contributions are typically called profit sharing contributions, but do not need to be tied to profits
- 👍 Participants will typically have access to mutual fund share classes with lower expense ratios than if they buy outside of the retirement plan
- 👍 Employees can roll over retirement accounts from former employers’ retirement plans, making it easier to consolidate retirement savings
- 👎 Certain highly-paid individuals may not be able to defer as much as they want, unless the employer makes contributions to plan.
- 👎 There is an administrative cost since the business will need to hire a professional to handle administrative roles such as plan investing, tracking participant accounts, and compliance testing. These fees can be paid by the business and taken as a tax deduction, or these fees can be deducted from plan participants’ accounts.
Does the Company have to make any Contributions to the 401(k) Plan?
No, but depending on the retirement plan objectives and who will participate in the 401(k) plan, employer contributions may be needed to make the retirement program successful. If so, there are creative ways to allocate employer contributions.