401k Made Simple – Sort Of
By VICKY BROWN
If you’re an employer offering a 401(k) plan for the first time, there are all sorts of important factors to understand, including the setup process, regulatory responsibilities, and ongoing plan maintenance. So sure, offering a 401(k) can be a great benefit to employees, but it also comes with legal and administrative obligations.:
Now, this is a great time to remind you that this information is for general purposes only, I’m not an attorney or financial expert (and I don’t even play one on TV), so this is absolutely not to be considered tax or legal advice.
OK – onward. First things first: What exactly is a 401(k)? Well, let’s break it down.
A 401(k) is a retirement savings plan sponsored by an employer. It’s named after the section of the Internal Revenue Code that created it back in 1978. But don’t worry, you don’t need to memorize tax codes to understand how it works.
At its core, a 401(k) is a just a financial program that allows employees to save and invest for their future. And here’s where it gets really interesting – there’s more than one type of 401(k).
Let’s talk about the three main types:
The traditional 401(k): This is the granddaddy of 401(k) plans, and there’s a good reason – it’s the most common type. Here’s how it works and why it’s so popular.
The big draw of a Traditional 401(k) is the upfront tax break. When employees contribute to this type of plan, they’re using pre-tax dollars. But what does that really mean?
Well, imagine one of your employees, we’ll call her Sarah, makes $60,000 a year. She decides to contribute 10% of her salary to her Traditional 401(k). That’s $6,000 a year or $500 a month. And that $6,000 comes out of her paycheck before taxes are calculated. So, as far as the IRS is concerned, Sarah only made $54,000 this year.
This has two immediate benefits:
- Sarah’s taxable income is reduced, which means she’ll pay less in income taxes this year – and
- She’s able to invest more money than she could if she was investing after-tax dollars.
It’s like the government is giving Sarah a discount on her retirement savings.
But here’s where the “catch” comes in, and it’s important that both you and your employees understand this: Because the tax man will always get his due. When Sarah reaches retirement age and starts withdrawing money from her Traditional 401(k), she’ll need to pay income taxes on those withdrawals.
Why? Because she got a tax break when she put the money in, so she pays the taxes when she takes it out. It’s essentially a tax deferral strategy.
Now, this can still be advantageous. Many people find themselves in a lower tax bracket during retirement than they were during their working years. So Sarah might end up paying less in taxes overall by deferring them to retirement.
But there’s more to consider. The money in a Traditional 401(k) grows tax-deferred. This means that while it’s in the account, any interest, dividends, or capital gains aren’t taxed. This allows for potentially faster growth compared to a taxable investment account.
Another important point: Traditional 401(k)s are subject to Required Minimum Distributions (RMDs). This means that starting at age 72, account holders must start withdrawing a certain amount each year, whether they need the money or not. This is the government’s way of making sure they eventually get those deferred taxes.
So, who might benefit most from a Traditional 401(k)?
- Employees who expect to be in a lower tax bracket in retirement
- Those who want to lower their current taxable income
People who want to delay paying taxes on their retirement savings
As an employer, offering a Traditional 401(k) can be an amazing benefit. It allows your employees to reduce their current tax burden while saving for the future. And remember, any matching contributions you make as an employer also go into the account pre-tax.
And here’s a pro tip: While Traditional 401(k)s are the most common, it doesn’t mean they’re the only option or the best fit for everyone. That’s why many employers are now offering both Traditional and Roth 401(k) options, giving employees the flexibility to choose based on their individual financial situations and retirement goals.
So “what” you say “is a Roth 401k”?
This is a relatively newer kid on the block. It’s like the Traditional 401(k)’s rebellious younger sibling who likes to do things differently.
With a Roth 401(k), employees make contributions with after-tax dollars. What does this mean? Let’s go back to our friend Sarah who makes $60,000 a year and wants to contribute 10% to her 401(k).
If Sarah chooses the Roth option, her $6,000 contribution comes out of her paycheck after taxes have been calculated. So, unlike with the Traditional 401(k), her taxable income for the year stays at $60,000. She’s paying taxes on that $6,000 now.
You might be thinking, “Wait a minute. Why would anyone choose to pay taxes now when they could put it off?” Well, here’s where the Roth 401(k) really shines: When Sarah reaches retirement and starts taking money out of her Roth 401(k), she won’t owe a single penny in taxes. Not on her contributions, and not on any of the growth her investments have seen over the years.
Let that sink in for a moment. All that compound growth over decades? Tax-free. That’s effectively planting a money tree and never having to pay taxes on the fruit it bears.
And this can be a huge advantage, especially for younger employees or those who expect their income (and their tax bracket) to be higher in retirement. If Sarah believes tax rates will go up in the future, or if she expects to be earning more in retirement (maybe from other investments or a pension), paying taxes now at her current rate could save her a bundle down the road.
Another big plus of the Roth 401(k)? Unlike Roth IRAs, there are no income limits for participation. So even your highest-paid employees can take advantage of this option.
Now, here’s a nugget of information that often surprises people: If you, as an employer, offer a match on 401(k) contributions (and kudos to you if you do!), that match will always go into a Traditional 401(k), even if the employee is contributing to a Roth. Why? Because the match is considered employer money, and it hasn’t been taxed yet.
So, who might benefit most from a Roth 401(k)?
- Younger employees who have time to let tax-free growth work its magic
- Those who expect to be in a higher tax bracket in retirement
- Employees who want more tax diversification in retirement
- People who want the option to leave a tax-free inheritance
“… Many people find themselves in a lower tax bracket during retirement than they were during their working years. So Sarah might end up paying less in taxes overall by deferring them to retirement“
And finally, there’s the Safe Harbor 401(k): This is the 401(k) plan’s VIP option, designed with a specific purpose in mind. Getting around the non-discrimination testing requirements.
So, what are these “non-discrimination tests” we’re talking about? Well, the IRS wants to make sure that 401(k) plans benefit all employees, not just the higher-paid ones. So they require most 401(k) plans to pass annual tests to prove they’re not favoring the big earners. These tests can be complex, time-consuming, and if you fail them, potentially costly to correct.
Enter the Safe Harbor 401(k). It’s designed to automatically pass these non-discrimination tests. It’s like getting a hall pass from the IRS. Sounds great, right? Well, it can be, but there’s a catch (of course).
In exchange for this “safe harbor” from testing, you, the employer, are required to make contributions to your employees’ accounts. And not just any contributions – they need to be substantial and immediately vested. This means the money you contribute is immediately 100% owned by your employees.
There are a few ways you can structure these contributions such as
Non-elective contributions: Where you contribute 3% of each eligible employee’s compensation, regardless of whether they contribute to the plan themselves. It’s like giving everyone a 3% raise, but it goes straight into their 401(k).
There’s a basic match: You match 100% of the first 3% of compensation that an employee contributes, plus 50% of the next 2%. So if an employee contributes 5% of their salary, you’re kicking in 4%.
And the enhanced match: This has a few requirements around it, but one of the most common formulas we see is you match at least 100% of the first 4% of compensation that an employee contributes.
Now, you might be thinking, “Hey, that sounds expensive!” And you’re not wrong. Safe Harbor plans do require a significant financial commitment from you as the employer. But before you run for the hills, let’s talk about why you might consider it:
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It’s simpler – with a Safe Harbor plan, you can say goodbye to the stress and complexity of annual non-discrimination testing.
There are higher contribution limits for highly compensated employees: Without the restrictions imposed by failed non-discrimination tests, your higher-paid employees (often including owners and executives) can max out their contributions.
It helps attract and retain talent: A guaranteed employer contribution can be a powerful recruiting and retention tool.
Excellent tax benefits: Your Safe Harbor contributions are tax-deductible for your business.
It forces you to save. If you’re the type of business owner who struggles to save for retirement because you’re always reinvesting in your business, a Safe Harbor plan ensures you’re setting aside money for the future.
Safe Harbor 401(k) plans can be particularly attractive for small businesses where owners want to maximize their own contributions without the worry of failing non-discrimination tests. They’re also great for companies with low participation rates among rank-and-file employees.
But here’s the kicker – and it’s important to understand this – once you’ve started a Safe Harbor 401(k), you’re generally committed to making those contributions for the full year. You can’t just change your mind halfway through because cash is tight.
So, is a Safe Harbor 401(k) right for your business? Well, that depends on your specific situation. Here are some questions to consider:
- Are you currently struggling to pass non-discrimination tests?
- Do you have the cash flow to support mandatory contributions?
- Are your highly compensated employees (including yourself) limited in how much they can contribute to the current plan?
- Would a guaranteed employer contribution help with employee recruitment and retention?
Remember, offering a Safe Harbor 401(k) is a big decision. It’s not just about the money – it’s about your company culture, your long-term financial strategy, and your commitment to your employees’ financial well-being.
My advice? Run the numbers. Talk to your financial advisor or a benefits consultant. Consider your business goals and your workforce needs. A Safe Harbor 401(k) can be a powerful tool, but like any tool, it needs to be the right fit for the job at hand.
Another pro tip: If you decide to go the Safe Harbor route, make sure your employees understand the value of what you’re offering. This isn’t just another benefit – it’s a significant investment in their future. Communicate it clearly, and you might just find that it becomes one of your most appreciated employee benefits.
Remember, there’s no one-size-fits-all answer in retirement planning. By providing these choices, you’re not just offering a retirement plan – you’re empowering your employees to take control of their financial future. And that, my fellow entrepreneurs, is how you build a loyal, engaged, and financially savvy workforce.
Now in next week’s episode, we’ll take all about what you need to do to actually set a plan up.