A retirement plan shows that you are invested in the futures of your employees and gives employees the opportunity to plan ahead and care for their financial futures. The 401(k) is a type of retirement account, aptly named after its section description in the IRS tax code (26 U.S. Code § 401(k)). This code section allows you to provide employees with an option to receive their earnings in cash or in a deferred compensation structure.
There are two main ways that employees can contribute to a 401(k) plan: they can do so on a pretax basis, meaning that their deferrals will come out of their checks prior to any applicable taxes being taken out, or they can do so on a post-tax basis, meaning that all applicable taxes will be taken out of their pay prior to making the contribution to their retirement account.
The pretax option, also known as the traditional 401(k), was written into the tax code back in 1978. The traditional 401(k) allows employees the option of setting aside a portion of their compensation towards their retirement, in which they will not pay taxes on their contributions to the plan or their earnings until they reach retirement age and take the money out.
The post-tax option, also known as the Roth 401(k), was written into the tax code in 2006. This option requires that employees pay taxes on their contributions at the time at which they are made, but when they take a distribution at retirement, they no longer need to pay taxes on that money since they have already done so. This favorable tax treatment holds true as long as five tax years have passed from when the first contribution was made to the Roth IRA. Employers are slowly adding this option to their plan documents, as it gives their lower earning employees the opportunity to contribute post-tax while they have a lower tax rate, given that they are likely predicting their tax rate to be higher at retirement than at the time of their contribution.
*NOTE there is another option, called a SIMPLE 401(k) that is an option for some small employers. As the rules for the SIMPLE 401(k) are vastly different from the other retirement plan options listed above, we will primarily focus on the rules around the other types of 401(k) plans here.
You have the option of matching your employee contributions to the plan. Most employers who contribute do so based on providing a certain percentage up to a specific contribution limit (e.g., 50% of the first 6% of employee contributions). The added benefit of employer matching encourages employees to save for their retirement by offering an incentive to do so. This is not a requirement, but many employers tend to offer some matching contribution whenever possible.
Some employers choose to make a contribution on behalf of their employees that is not tied to the employee contribution. This is called a non-elective contribution, and the contribution will be made to all employees regardless of whether or not they choose to contribute to the 401(k) plan. This is essentially a form of profit sharing instituted within the retirement plan.
As with many benefits allowed by the IRS, there are limits to how much employees can contribute to the plan. These limits are set on an annual basis.
Typically employees will have the options of choosing between several different mutual fund options, bonds, stocks, cash, and a variety of other investment options. Some plans offer employees the option of choosing a time managed portfolio, which allows the 401(k) administrator the option of selecting a mix of investment options for the employee based on their predicted retirement age.
Many employers have chosen to incentivize employees to stay within the organization for a certain timeframe in order to reap the benefits of the company match. This is typically done through a vesting schedule. In most cases, employee contributions are vested at 100%. This means that the employee is entitled to 100% of their contributions when they leave the company. When it comes to the company match, however, the vesting schedule may vary significantly from company to company.
Plan sponsors must test traditional 401(k) plans each year to ensure that the contributions made for rank-and-file employees – those considered non-highly compensated – are proportional to those made for owners and managers. There is also testing to determine whether the plan is “top heavy,” meaning the total value of key employee’s plan accounts is more than a certain percentage of the total value of the plan assets overall.
Should the plan fail one of these tests, the organization has a few options as to how to rectify the issue, and the method used to fix it often depends on which test was failed. When the plan is “top heavy,” generally the employer is required to contribute a percentage of compensation for all non-key employees to the plan. When the plan is deemed to have discriminated against non-highly compensated employees, there are a couple of methods the company may use to fix the issue. One option is to return a portion of plan deposits made by highly compensated employees back to such employees. A second option is to make some additional contributions to non-highly compensated individuals. Such contributions are typically called Qualified Non-Elective Contributions or Qualified Matching Contributions.
There are specific requirements regarding when and how employees can access their retirement funds. There are some unique requirements, but generally distributions of elected deferrals cannot be made outside of the following events:
- The employee dies, becomes disabled, or otherwise has a severance from employment.
- The plan terminates and no successor defined contribution plan is established or maintained by the employer.
- The employee reaches age 59½ or incurs a financial hardship.
Distribution rules can be difficult to maneuver, but typically it is the responsibility of the employee to understand the limits imposed on 401(k) plan distributions. A third party administrator is one of the best resources to help employees in this regard.
The 401(k) is widely popular benefit—many employees even expect employers to provide it. If you’re able to offer a retirement plan, the 401(k) is a good investment—for your employees and for you!