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Updated Sep 05, 2024

401(k) Plan: What It Is and How to Choose One

A 401(k) is a benefit employers offer that incentivizes employees to save money for their retirement. Here's how to choose one for your business.

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Written By: Jennifer PostBusiness Operations Insider and Senior Writer
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Retirement benefits like 401(k) plans give employees an advantage as they prepare for their retirement years. They’re also an excellent job perk that helps employers attract and retain the top talent needed to grow a business. Many types of 401(k) plans exist, including options for self-employed individuals. We’ll explain 401(k) plans and help employers assess their needs to choose the right plan for their organization.

What is a 401(k) plan?

A 401(k) plan is part of an employee benefits package that allows employees to contribute a portion of their wages to individual accounts to save money for retirement. The money is deducted from their paycheck and deposited directly into their 401(k) account. 

Here are some notable facts about 401(k) plans: 

  • Most 401(k) plans are tax-deferred: Aside from Roth 401(k) plans (more on this plan type below), 401(k) plans are tax-deferred, meaning federal or state taxes aren’t paid on earnings until the money is withdrawn. For example, if you earn $70,000 for the year but contribute $2,000 to your 401(k) plan, your Form W-2 will show federal and state taxable income of only $68,000 ($70,000 – $2,000). However, you still pay Social Security and Medicare tax on the full amount before 401(k) contributions.
  • The IRS sets contribution limits: Because 401(k) contributions are not included in employee taxable income, the IRS sets limits on how much employees can contribute to a 401(k) plan each year.
  • Employers can contribute to 401(k) plans: To encourage plan participation, employers can offer a 401(k) match or otherwise contribute to their employees’ 401(k) plans. The amount will vary by company, but businesses may offer to match between 25 and 100 percent of contributions up to a specific percentage of the employee’s salary. 
  • 401(k) plan participation eligibility varies: Participation eligibility differs by company. Some allow employees to start contributing to a plan as soon as they are hired while others require a waiting period of one month to a year. 

Despite the availability of other types of retirement plans, 401(k) plans are highly recommended. “While MEPs [multiple employer plans] and state mandates are all the talk on an industry level, the 401(k) is still the best tried-and-true way to save at work,” said Andrew Meadows, senior vice president of human resources at Ubiquity Retirement + Savings. “With high contribution limits and the ability to lower costs, the 401(k) is becoming leaner and a more popular option for small businesses.”

Did You Know?Did you know
Offering a 401(k) plan benefits small businesses by boosting employee morale. When their financial security is protected, employee turnover can be significantly reduced.

What types of 401(k) plans are there?

Here’s a quick overview of the most popular types of 401(k) plans. (You can find a complete 401(k) plan breakdown on the IRS website.)

Traditional 401(k) plan 

Considered the most flexible plan, a traditional 401(k) allows employees to make pretax contributions through payroll deductions. Traditional 401(k) plans are often offered with an employer match program. These contributions are not always vested, meaning employees do not own the matching contributions until they meet certain provisions:

  • Contribution limits: In 2024, the annual contribution limit is $23,000, with an additional $7,500 “catch-up” for employees aged 50 and older.
  • Employer match: The amount contributed by the employer is not vested automatically, meaning the employee may lose part or all of the employer contribution if they leave the company before a specified time. The contribution amount depends on the employee’s annual contribution and the employer’s plan.

Safe harbor 401(k) plan 

This plan is similar to the traditional plan but mandates that employer contributions be vested as soon as they’re made. There are three types of safe harbor plans, two of which have employer-match provisions. Safe harbor plans are also not subject to the nondiscrimination tests that traditional 401(k) plans must undergo:

  • Contribution limits: In 2024, the annual employee contribution limit is $23,000, with an additional $7,500 “catch-up” for employees aged 50 and older.
  • Employer match: Yes. Contributions are guaranteed to be vested. The amount depends on the employee’s annual contribution and the employer’s plan.

SIMPLE 401(k) plan

The Savings Incentive Match Plan for Employees (SIMPLE) 401(k) typically is a startup 401(k) plan. Only businesses with fewer than 100 employees can offer this plan:

  • Contribution limits: In 2024, the annual employee contribution limit is $16,000, with an additional $3,500 “catch-up” for employees aged 50 and older.
  • Employer match: Yes. Employers can make up to a 2 percent nonelective contribution or up to a 3 percent matching contribution.

Roth 401(k) plan

A Roth 401(k) plan is funded with post-tax income, so money saved is not subject to any federal or state taxes as long as the investor reaches the age of 59 1/2 before withdrawal:

  • Contribution limits: In 2024, the annual employee contribution limit is $23,000, with an additional $7,500 “catch-up” for employees aged 50 and older.
  • Employer match: Yes. Employers can make pretax or after-tax matching contributions.

Solo 401(k) plan

Solo 401(k) plans, also known as self-employed 401(k) plans, are for self-employed individuals or businesses with only one employee. They allow contractors and sole proprietors to have a retirement savings option. Self-employed individuals can choose the traditional or Roth structure for solo 401(k) plans:

  • Contribution limits: In 2024, the annual total contribution limit is $69,000, with an additional $7,500 “catch-up” for employees aged 50 and older.
  • Employer match: Not applicable.

Profit-sharing plans

With a profit-sharing plan, an employer sets aside a portion of its pretax income to share among its employees. This plan type provides flexibility in how much money the employer contributes. Several varieties of profit-sharing plans are under this umbrella, including pro-rata plans, new comparability plans and age-weighted profit-sharing plans:

  • Contribution limits: For 2024, the annual contribution limit for profit-sharing plans is $69,000 or 100 percent of the employee’s salary, whichever amount is lower.
  • Employer match: These plans are 100 percent employer-funded.

403(b) plans

A 403(b) retirement plan is a tax-sheltered account designed for teachers; it’s sometimes also used by eligible not-for-profit groups, including religious organizations. Contributions are pretax and earnings are not taxed until they are distributed:

  • Contribution limits: In 2024, the annual contribution limit is $23,000, with an additional $7,500 “catch-up” for employees aged 50 and older.
  • Employer match: Yes. Employer-matching contributions are pretax.

While other 401(k) plans exist, many are more complex and are unlikely to suit small businesses. “Larger companies with a 401(k) may want a special variety for their type of business,” Meadows explained. “However, small businesses will likely want to keep it simple to avoid any complicated compliance worries.”

TipTip
You can borrow from a 401(k) plan without incurring tax penalties for early withdrawal, but you will have to repay the borrowed amount through future contributions.

How to choose a 401(k) plan

Meadows advises small businesses to provide the most robust 401(k) plan they can afford — and to implement one as soon as possible. “Today, there are more and more providers helping small businesses avoid high-cost funds and access manageable monthly administration fees,” Meadows explained. “This may vary from business to business, but the sooner you can set up a 401(k) plan, the better.”

To choose the best type of 401(k) plan for your business, determine the answers to the following questions: 

  • Why do you want to establish a 401(k) plan? According to Meadows, business owners must determine why they’re establishing a 401(k) plan to choose the right one for their organization. “Is this a plan for the owner to put as much money as possible away for their own future or is this primarily a benefit for employees? Without a doubt, this is a great decision for any company that expects to put away more than [the individual retirement account (IRA) limit] per year,” Meadows explained.
  • How large is your business? Your business size may direct you toward the right plan. For example, the SIMPLE 401(k) plan is available to businesses with less than 100 employees while the Solo 401(k) plan is intended only for self-employed individuals or businesses with one employee.
  • Do you want to share profits from your business? A profit-sharing plan is intended to make predetermined contributions of a percentage of company profits to employee retirement plans. This type of plan only accepts employer contributions as employees cannot contribute to it.
  • Do you want to have tax-free income in retirement, as opposed to reducing taxable income now? Contributing to a Roth 401(k) plan does not reduce current taxable income, but you don’t have to worry about tax on qualified withdrawals later.
  • Do you want to place vesting restrictions on employer-matching contributions you make on behalf of employees? Traditional 401(k) plans allow you to place vesting restrictions while safe harbor 401(k) plans require all employer contributions to be vested immediately.

When choosing the right plan for your business, you should also consider plan administration complexity and costs: 

  • Complexity: Some 401(k) plan types are more challenging to establish and maintain than others. As the name suggests, the SIMPLE 401(k) is a basic plan for qualifying businesses and is a great option if you want to avoid complexity. 
  • Costs: Your budget and resources will also guide your plan choice. Additionally, administrative and custodial fees vary by plan type and institution, so research costs thoroughly before committing to a plan. 401(k) administrative and custodial fees can consume a significant portion of employees’ return on investment easily, so evaluating fees is crucial.
TipTip
Use a 401(k) calculator to estimate the future worth of your plan under various scenarios, ensuring you're saving for the retirement you envisioned.

Is a 401(k) plan right for your business?

Small business owners typically have the following concerns about implementing a 401(k) plan: 

  • They worry that paying for a 401(k) plan would affect the business’s success if margins are already tight. 
  • They fear that plans are complicated and involve a lot of jargon.
  • They’re concerned that unexpected management and investment fees will appear.

However, according to Ben Smith, founder and Certified Financial Planner at Cove Financial Planning, 401(k) plans are viable options for many small businesses with numerous benefits. “Generally speaking, any business that seeks to provide a relatively simple and low-cost plan may consider a 401(k),” Smith asserted. 

Additionally, a 401(k) plan can help your business attract and retain top talent. “One benefit for even the smallest businesses to have a 401(k) plan for employees is simply to attract and retain talent,” Smith noted. “Many job seekers and current employees will value the added benefit of having access to a retirement plan offered by their employer and they may look elsewhere for work if a business does not offer one.”

To allay any misgivings and get your employees on board with the plan, Meadows offers the following advice: 

  • Explain the plan thoroughly to employees: While the IRS website provides basic information about 401(k) plans, your employees might not know what the plan means. Meadows advised employers to use plain language when explaining the plan to their employees.
  • Consult a financial advisor: Many employers may need help thoroughly understanding the 401(k) plan and determining the best contribution scenario for the business. An experienced financial advisor can guide you on the best decisions. “The best financial advisors are the people who have already done it,” Meadows noted.
Key TakeawayKey takeaway
Companies of any size can offer a 401(k) plan. If you're new to the process, connect with a financial advisor who can help you find the best retirement plan option for your company.

What’s the difference between a 401(k), a mutual fund and a traditional or Roth IRA?

As business owners evaluate various options, it’s important to understand the differences between 401(k) plans and IRAs and how they relate to mutual funds. 

Here’s how it works.

“401(k)s contain mutual funds, but the fees for those funds are lower than an individual could purchase on their own,” explained Cynthia Keaton, vice president of human resources at Secure HR Pro, LLC. “There is a requirement for company oversight, so there is a constant review of the funds to ensure they are the best options for employees. An individual who selects their own [mutual] funds does not have the advantage of this expertise monitoring the funds and a financial planner may have an incentive to keep individuals in higher-fee funds.”

Meadows defines a mutual fund as “the investments your pretax or post-tax dollars go into so that they can grow into a valuable nest egg for your retirement.”

In contrast, traditional and Roth IRAs are individual retirement accounts not tied to your employer. Only one person can be on an IRA account. The money also grows tax-free and a Roth IRA isn’t tied to an employer.

“This means that when the owner pulls money out in future years, it comes out tax-free,” Smith explained. This part of a Roth IRA is very similar to a Roth 401(k).

TipTip
401(k) plans have an employer oversight requirement that allows employees to invest in mutual funds guided by professionals at lower fees. Roth IRAs are primarily based on tax-free savings incentives.

The future of 401(k) plans 

Social Security funds continue to be depleted and workers are increasingly concerned about the future of retirement.

Currently, one-quarter of Americans 65 and older receive 90 percent of their income from Social Security payments. However, the 2021 Social Security Trustees report found that, without any intervention, funds will run out by the mid-2030s. The report estimates that Social Security funds will only pay 78 percent of scheduled benefits at that time.

Roger Lee, co-founder of Human Interest, agrees that the United States has a looming retirement crisis.

Roughly half of Americans are only saving 10 percent of their annual income or less toward all of their financial goals, falling short of recommended retirement savings strategies.

“While it’s essential to have a discussion about financial responsibility and planning, it’s also important to recognize that many workers don’t have access to 401(k) plans, which has become the dominant means of saving for retirement,” Lee explained.

However, if you are one of the lucky people with access to a 401(k) plan, these plans have become the forerunner in addressing retirement needs.

“[Social Security] and pension plans are of the past,” said Brian Menickella, co-founder of financial services firm The Beacon Group of Companies. Menickella believes the financial future of retirement is bright, even with the continued concern around Social Security.

Best 401(k) employee retirement plan providers

Choosing the best employee retirement plan for your business means examining your requirements and budget and finding an option that suits your employees’ needs. When selecting a 401(k) plan, find a reputable vendor with reasonable fees and excellent resources to guide you. 

Consider the following top options when beginning the process of setting up a 401(k) plan for your team: 

  • ShareBuilder 401k: If low fees are a priority, consider ShareBuilder 401k. It offers payroll integration, solo 401(k) plans and total investment fees under 1 percent. Our ShareBuilder 401k review explains this vendor’s plan options, administration services and educational resources. 
  • ADP Employee Retirement: Small businesses can benefit from ADP’s all-in-one solution with payroll integration. Read our detailed ADP Employee Retirement review to learn about this company’s transparent pricing and full-service retirement plan administration.
  • USA 401k: USA 401k offers transparent pricing and fee details for growing businesses. You and your employees can choose from diverse fund offerings. As our USA 401k review explains, you’ll never outgrow its services because the company offers plans for an unlimited number of employees.

Start saving with a 401(k) or other retirement plan

The most important thing to remember about contributing to a retirement plan is that the sooner you start, the better. This is true both for you and your employees. By creating a 401(k) plan for your business, you and your employees can start feeling more secure about your financial future today.

Sally Herigstad contributed to this article. Source interviews were conducted for a previous version of this article. 

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Written By: Jennifer PostBusiness Operations Insider and Senior Writer
Jennifer Post has spent nearly 10 years advising small business owners on best practices for human resources, marketing, funding and more. She devotes her time to ensuring entrepreneurs are equipped with not only the knowledge necessary to launch and grow a successful business but also the software products and tools that are essential for everyday operations. At Business News Daily, Post covers software and services ranging from CRM and credit card processing solutions to legal services and email marketing platforms, while also providing guidance on sales matters and workforce management. Post, who has a bachelor's degree in journalism, has also shared her expertise through Fundera, The Motley Fool, HowStuffWorks and more. Most recently, she has focused on risk management and insurance, two key areas business owners must understand to sustain their enterprises.
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