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A Comprehensive Guide to 401(k) Plans and the Current Trends

A Comprehensive Guide to 401(k) Plans and the Current Trends

May 02, 2024

What is a 401(k)?

A 401(k) plan is a type of defined contribution retirement plan that allows employees to choose to set aside a portion of their wages into an investment account on a pre-tax basis. A lot of times, the employers may match their employees’ contributions.

Because of its tax-deferred feature, a 401(k) can be a great tool to help fund an employee’s retirement. It allows your investment to grow faster as the entire balance (including what would have been taxed) continues to compound.

In today’s environment where competition for workers has rapidly tightened, a 401(k) plan can help employers improve benefits to retain talent.

Benefits of a 401(k) plan

One of the key advantages of a 401(k) plan is its higher contribution limit (compared to an IRA). The general contribution limit is $22,500 in 2023 for employees under 50 and an extra $7,500 for those 50 or older (2024 limits are $23,000 or $30,500). Contributions matched by the employers are typically tax-deductible, reducing the overall taxable income of the business.

In recent years, many states including California, Colorado, Illinois, Massachusetts, Oregon, Washington, and Virginia have begun mandating retirement savings programs for workers (more than 20 other states are likely to follow suit soon). Employees must enroll in the state's program, or their employers must establish their own qualified plan for workers to participate. Therefore, now is an excellent time for businesses to meet state requirements and enhance employee welfare.

SECURE 2.0 Act passed in late 2022 provides extra incentives for small-to-medium businesses (with 100 or less employees) to set up retirement savings plans for their employees. The new legislation offers 3 tax credits:

  • Employer contribution tax credit
  • 2) Startup cost tax credit
  • 3) Automatic enrollment tax credit. New plans established after 2022 could potentially claim a maximum of $55,000 in the first year.

Potential Drawbacks of a 401(k) plan

For a traditional 401(k) plan, the nondiscrimination test (NDT) is required annually. NDT exists to make sure the retirement plan does not unfairly favor owners, managers, and other high-pay employees over rank-and-file workers. Two major components of the NDT are the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test. Together, they ensure the difference between the contribution rate of highly compensated employees and that of non-highly compensated employees stay within a range. Compliance with the NDT can be a burden for small businesses since they may lack the resources and expertise to actively track contributions and to manage the complexities of these tests. If a plan fails these tests, the business must take corrective measures such as refunding contributions to HCEs or increasing contributions to NHCEs.

The Department of Labor and the IRS require sponsors of 401(k) plans to file Form 5500 to provide transparency on a plan’s financial condition, investments, and operations. A large sponsor with more than 100 plan participants is required to file Form 5500, whereas a smaller sponsor with less than 100 participants can file Form 5500-SF.

How to set up a 401(k) plan

The first step is to establish goals and objectives by assessing the needs of the business and its employees (considering budget, the expected level of employee participation, and the goals for the plan). A company can then decide on the type of 401(k) plan and its features, including matching contributions, eligibility requirements, loan provisions etc.

The second step is choosing a third-party administrator (TPA), a custodian, and an investment advisor. A TPA helps handle most of the administrative work, such as enrollment processes, compliance testing, and government reporting. A custodian will function as a trust to hold and safeguard the plan’s assets. An investment advisor will help select a range of investment options that participants can invest in. It is critical to have a range of investment options that will allow participants to diversify their investments. Available 401(k) investment options often include a mix of index funds, mutual funds, and target-date funds.

In addition, the employer should send communication documents to plan participants regularly to update changes to plan features, administrative changes, and annual summary reports.

Other features of 401k plans

  1. Roth 401(k): Similar to a Roth IRA, a Roth 401(k) takes after-tax contributions and makes withdrawals tax-free. An edge which a Roth 401(k) has over a Roth IRA is that a Roth 401(k) does not have income restrictions. Regardless of your income level, you are eligible to contribute to a Roth 401(k).
  2. 401(k) loan: Normally, early withdrawals from a retirement savings account will result in taxes and additional penalties. However, the unique feature of a 401(k) loan provision allows an employee to borrow from his or her 401(k) plan without paying any penalties. The repayment and interest simply return to the retirement savings account.

Profit-sharing: A 401(k) plan can be designed to combine with a profit-sharing plan. This allows employees to share the earnings with the company. Unlike traditional bonus payments through paychecks, profit-sharing plans enable workers to receive the benefits without jacking up their taxable income. Contributions to profit-sharing plans are tax-deductible for employers and are not subject to FICA taxes. Additionally, these plans allow employers to assess their finances before deciding on the contribution.

 

Retirement plan withdrawals before age 59½ may be subject to taxation and penalties when withdrawn early.