Updated: Jun 14, 2021
A 401(k) plan is an employer-based retirement savings account funded through pre-tax payroll deductions from employees' pay. In the case of a Roth 401(k) plan, the deduction is taken after tax. Some employers offer several benefits including a 401(k) plan to their employees as part of their benefits package.
What is a 401(k) Plan?
A 401(k) plan is a special type of account, named after a section of the United States Internal Revenue Code. Employees fund their 401(k) account through automatic payroll deductions, which are taken before taxes are paid on the balance. Employers can match some or all of those contributions, depending on how they choose to contribute.
The funds in the 401(k) account can be invested into bonds, stocks, and other kinds of funds. Taxes are not taken on gains, dividends, or interest that accrue on the account until an employee withdraws from their earnings. The fact that employees get a tax break when contributing to a 401(k) plan is perhaps one of the most attractive benefits of having a 401(k) savings plan. Recently, President Joe Biden proposed to replace the tax break with a tax credit, to make the benefit of putting money in 401(k) plans equal to all cadres of employees.
In the subsequent paragraphs, we'll be going over 7 important things that both employers and employees need to know about contributing to a 401(k) plan.
1. How 401(k) Plans Work
To begin with, the essence of contributing to a 401(k) plan is to keep money aside for retirement. This means that until retirement, it will be difficult to draw from the account. Employees save money in a 401(k) plan through tax-deferred (tax is not taken until they withdraw from the plan) contributions deducted from their regular income. Employees make contributions by deferring some of the salaries they earn and put them into a retirement savings plan.
Remember that income tax is taken from your regular income as an employee, but a 401(k) plan lets you avoid paying income taxes on the amount of money you're currently paying into the account. There are two basic types of 401(k) plans — the traditional and Roth plans. They are the same in every aspect, but differ in how they're taxed. See section (5) below for further details on this.
2. Companies May Match Workers 401(k) Contribution
Employers can match some or all of the contributions their employees make to the plan. Many employers make contributions to their employees' 401(k) plans as part of their employee benefits plan. When matching their employees' 401(k) contributions, many employers often use different formulas to calculate that match.
For instance, an employer might contribute $1 or 50¢ for every dollar an employee contributes up to a certain percentage of the employee's earnings. To get the full employer match, it is advised that employees should contribute enough money to their 401(k) plans. Employers can contribute in any of 3 ways:
Matching Contribution: Employer puts in money as long as the employee is contributing
Non-elective Contribution: Employers may elect to put in a determined percentage of the employee's pay, whether or not they're contributing to their 401(k) plans.
Profit-sharing Contribution: The employer may decide to set a particular amount into the plan if it is profitable.
Note that employer contributions are always pre-tax (before taxes are deducted), meaning that all contributions from the employer will be taxed when an employee eventually withdraws.
3. 401(k) Plans Have Contribution Limits
There are annual dollar limits set by the Internal Revenue Service (IRS) on employee elective deferral. But this changes periodically, typically each year, due to inflation (mostly varies by $500). Employees and employers can only make contributions to a 401(k) plan, up to this limit per year. The limit is usually defined by the worker's salary, age, and plan. The IRS set limit is $19,500 in 2020 and 2021, or $26,500 for workers 50 years and older.
For employers looking to max out the annual contribution to their 401(K), the Financial Industry Regulatory Authority provides a guide for achieving this. If the employer elects to contribute too, the maximum employee/employer contribution to 401(k) plans for employees younger than 50 years for 2021 is $58,000, or 100% of employee compensation (whichever is lower). But for those 50 years and older, the limit is $64,500 for 2021.
4. There Are Fees for Contributing to 401(k)
401(k) plans come with fees when you start investing, but many employees do not know this. Larger plans have lower fees but fees also depend on the number of enrollees and the provider of the plan. The fees typically range from 0.5-2% of the plan assets. The government has already instructed providers and employers to provide full disclosures to employees, explaining the fees they pay for contributing to their 401(k) savings. Employees can also check with the manager of the plan for full details on the applicable costs.
5. Traditional 401(k) and Roth 401(k)
Employees have the liberty of choosing between the traditional 401(k) plan and the Roth 401(k) plan. As an employee, you can choose either or both of them — if the employer offers both. But keep in mind that when you put money in both traditional 401(k) and Roth 401(k), the total contribution to both accounts still must not exceed the set limit for one account (e.g. $19,500 for employees under 50 years).
Initially, employees had access to just the traditional 401(k) until the Roth 401(k) plan was introduced in 2006. See more details on the Roth 401(k) here. In this case, employees are allowed to put in after-tax money to their Roth 401(k) in exchange for tax-free growth and tax-free withdrawals later in the future. In other words, when you're retired and need to withdraw, you can make withdrawals tax-free. Note that any employer match will typically go into a traditional 401(k), employees can choose to divide their contributions between the two plans or opt for any of them.
6. Employees Can Choose From a Selection of Funds in Their 401(k)
In a 401(k) plan, the employer will select the investment choices to be offered to employees. Employees will then decide how to allocate their contribution among the investment options available. Most plans offer target-date funds, which are actively managed domestic and international stock funds, domestic bond funds, and money-market funds.
Target-date funds account for nearly 70% of what most 401(k) plans offer. Generally, employees have the liberty of choosing which investment options are most suitable to them.
7. Employees Can Withdraw Money Early from Their 401(k)
While money put into a 401(k) account is not to be withdrawn until retirement, employees can withdraw early from their 401(k) savings. However, any money withdrawn before age 59 ½ could be subject to a 10% early-withdrawal penalty. However, if an employee leaves their job at age 55, they can withdraw from their 401(k) account without penalty.
Workers are also allowed to borrow from a 401(k) plan, but just like every other kind of loan, they'll be paying interest on the loan plus a fee to take out the loan. One good thing about this is that the worker is essentially borrowing from their own account, so the interest and amount borrowed will go back into the 401(k) account.
Most companies that offer 401(k) plans do so mostly because they want to offer competitive employee benefits to their staff. Although, California does require employers that do not already sponsor an employee-retirement plan like 401(k) to participate in a state-run retirement program known as CalSavers.
But whatever the case is, knowing what is expected of you as an employer matching employees' 401(k) contributions will help you make the best decisions on how to match employees' contributions.