401k plans, named for the section of the Internal Revenue Code in which they are described, enable employees to contribute their own pre-tax money into a retirement account at work. By investing pre-tax dollars, employees can lower their income taxes in the years they contribute to a 401k.
In addition, employees don’t pay taxes on their 401k plan earnings until they withdraw them, usually at retirement. As an employer, you have the option to match some, or all, of your employee’s contributions – which further enhances the employee’s tax-deferred accumulations. Other features that make 401k plans attractive include:
A 401k approach could be right for you if you don’t want to be locked into funding a traditional defined benefit retirement program, which provides a pre-determined benefit when an employee retires. Said another way, a 401k is a defined contribution plan. This means the plan’s ultimate payout depends on how much the participating employee and your business (if you so choose) have paid into the employee’s 401k account, in addition to investment income. In other words, a 401k enables employees to contribute to their own retirement, while giving you the flexibility to determine if, and how much, you want to participate in the plan.
To reward employee loyalty, you can also establish a “vesting” schedule specifying when they can own your matching contributions. For example, employees can be fully vested for your contributions after a certain number of years (say 20% per year over five years). Employees are always fully vested for their own contributions and investment earnings.
As with all retirement plans, there are certain limitations. In 2021, if you are under 50 years old, you can contribute a maximum of $19,500. If you're 50 or older, you can make an additional catch-up contribution of as much as $6,500, for a total of up to $26,000. Those contribution limits change annually to track inflation.
Also, the contributions of highly compensated employees may be limited if lower paid employees do not contribute a sufficient amount. Each plan year, plan administrators must perform “top-heavy” testing to determine the maximum allowable contribution amount for key employees. So, if you start up a 401k plan, make sure you have a strong buy-in from all your employees.
Because contributions are made on a pre-tax basis, participants generally pay income taxes on their contributions when withdrawals are made, which is usually at retirement when they may be in a lower tax bracket. Withdrawals prior to age 59½ may be limited, and if available, may be subject to a 10% early withdrawal penalty. Withdrawals of after-tax contributions will not be taxed.
While there is an administrative burden involved in starting up a 401k plan, employees seek out and appreciate employers who give them a chance to save for their retirement. As a financial advisor, we can help you determine if a 401k plan is right for your business. Call us at any time to arrange for an appointment.
Partner, Financial Planner
Mike enjoys getting to know and understand his clients and their needs. Mike guides clients through the financial planning process to help them identify their goals and create a plan to achieve them. His expertise is working with folks nearing retirement and young couples looking to save for retirement and plan for their children’s education. Mike retired from the Air Force in 2014 and went back to school as a non-traditional student at the University of Northern Iowa. He obtained a bachelor’s degree in accounting. Mike is a CERTIFIED FINANCIAL PLANNER™, and a member of the National Association of Personal Financial Advisors, XY Planning Network and Fee Only Network.
