Planning for retirement can be overwhelming, especially when it comes to choosing the right retirement plan.
One of the most popular options is the 401(k) plan, which allows employees to save for retirement by contributing a portion of their paycheck.
In this blog post, we’ll explore everything you need to know about 401(k) plans, including the difference between Traditional and Roth plans, how to choose between the two, and how they work.
Additionally, we’ll discuss how small businesses can offer 401(k) plans to their employees, making it a valuable benefit for recruiting and retaining top talent.
So, whether you’re an employee looking to save for retirement or a small business owner considering offering a 401(k) plan, this post will provide you with all the information you need to make informed decisions.
What is a 401(k) plan?
A 401(k) plan is a savings plan offered by an employer to their employees for the purpose of accumulating money for retirement. These accounts have tax advantages for the employee enrolled in them.
The employees who voluntarily sign up for a 401(k) plan agree to have a percentage they choose deducted from their paycheck to be deposited into an investment account in their name.
These deposits are allocated to a wide range of investment options. Usually mutual funds.
There is a maximum contribution limit an employee can contribute annually. Employees are able to funnel $22,500 toward their 401(k) account for 2023 which is a $2,000 increase over the prior year.
This contribution limit is significantly higher than individual retirement accounts (IRAs).
IRAs for 2023 limits are only $6,500 which were increased by $500 over the prior year.
There are also catch-up contributions for employees over 50 years of age which is much higher at $73,500 for 2023.
Now, what are the tax advantages of 401(k)s?
In order to see what they are, we need to differentiate between two types of 401(k)s. Traditional 401(k)s and Roth 401(k)s.
Their main difference is in how they are taxed.
Traditional 401(k) contributions are pre-tax. What this means is that any contributions made to a traditional 401(k)s are deducted from the annual income and no income tax is paid on these contributions.
This means that the taxable income of the employee is reduced by the amount contributed. The taxes are collected at a future date once withdrawals take place, typically after age 59 and ½ or later.
Now Roth 401(k) contributions are post-tax. This means that taxes are paid in the form of income on all contributions. It does not reduce an employee’s taxable income at all.
The advantage of the Roth 401(k) is that no taxes will be withheld at a later date once withdrawals are made.
So, if the investments that were chosen were to really outperform, all of that gain can be withdrawn completely tax-free.
How to choose between a Traditional and a Roth 401(K)?
If you expect to be in a lower tax bracket after retirement you may want to opt for a traditional 401(k) and take advantage of the immediate tax break.
On the other hand, employees who expect to be in a higher bracket after retiring might opt for the Roth so that they can avoid taxes on their savings later.
You can also opt-in to both Traditional and Roth 401(k)s as long as the combined contribution amount does not exceed the annual limit.
What is “Employer Matching”
Besides tax advantages with the IRS, many employees also enjoy employer contributions as well. These are called “Employer Matching”.
There are various formulas to calculate that amount. Some employers will match 50 cents per every dollar the employee contributes up to a certain percentage of salary. Employer contributions are allowed to both Traditional and Roth 401(k)s.
401(k)s earn money based on the gains of the assortment of investments between stocks and mutual funds. The earlier one starts contributing, the more that money will grow based on the power of year-over-year compounding.
This means that returns generated are reinvested to provide even more returns of their own.
How do 401(k) withdrawals work?
Withdrawals can be tricky especially when the money is accessed before the account holder reaches a certain age or meets specific criteria.
If the money is withdrawn without meeting the age requirement and specific criteria, the IRS will charge a penalty.
This penalty is usually an additional 10% early distribution tax on top of any tax you owe. It is not advisable to take withdrawals unless you meet the criteria.
Having said that, most employers allow employees to take a loan from their 401(k)s.
In essence, employees take money out of their 401(k) accounts and then pay themselves back over time. It is important to consider if the employee leaves their job before repaying the loan back, they must pay the full amount they still owe in a lump sum or face a 10% penalty on the loan balance.
Now, what if you don’t need the money and want to let it sit there compounding hence looking to grow your nest egg as much as possible?
You can do that but within limits. After age 72, retired employees must withdraw at least a specific percentage from their 401(k) based on their life expectancy at the time.
What happens to your 401(K) once you leave your job?
Once your employment terminates whether voluntarily or otherwise, you have up to 4 different options depending on your situation:
1. Withdraw the money.
This is typically the least beneficial option since the money withdrawn will be taxable and a penalty will be applied if under 59 ½ at the time of withdrawal.
2. Roll over your 401(k) into an Individual Retirement Account (IRA).
This is a wiser choice since moving the account into an IRA with a brokerage firm will maintain the account’s tax-advantaged status. Keep in mind that you must rollover your 401(k) into an IRA within 60 days of the end of your employment to avoid taxes and penalties.
3. Leave your 401(k) with your old employer.
This option only depends on your old employer. Some will allow it and some will not. This option makes sense if you are satisfied with the investment options that the plan offers and if it is well managed.
4. Move your 401(k) to a new employer.
If you leave a job for another immediately after. This option like rolling over the account into an IRA will also maintain a tax-deferred status and avoid any penalties.
How can a small business set up a 401(k) plan?
There are 2 options:
1. Set it up on your own
Setting up a 401(k) for a small business on your own will require a good deal of research. It is important to do your due diligence in researching firms that provide recordkeeping and third-party administration services.
You will need to look into reputable mutual fund companies, brokerage firms, and insurance companies. You will have a fiduciary duty to ensure that the plan is providing a benefit to the participating employees.
Once you have selected a retirement service provider you will have to create a 401(k) plan document that complies with IRS code and outlines the details of your plan.
Then you will need to set up a trust to hold the plan assets. You will need to also maintain records of the 401(k) employee contributions and values and provide all the necessary information to the plan participants like a summary plan description and update the participants on investment changes and also communicate to them all fees associated with the account.
2. Set it up under a Professional Employer Organization (PEO)
Setting up a 401(k) via a Professional Employer Organization or PEO is a lot simpler since the PEO will handle all of this for you. They will make sure that you are complying with all regulations and do the plan testing for you.
Also, the fees you and the employees pay for the 401(k) are usually lower. PEOs provide this benefit as an added service to small businesses typically any fees associated with setting up a 401(k) are only passthrough fees.
They don’t add any additional fees on top while you take advantage of the economies of scale under the PEO.
The Huldisch Group can help you find the right PEO for your business anywhere in the US.
This service is FREE to you. Simply fill out the Contact Form to get started.
In summary, a 401(k) plan is a powerful tool for employees to save for their retirement, and it offers significant tax advantages for both employers and employees.
By understanding the differences between traditional and Roth 401(k)s, employees can make an informed decision about which plan is best for their individual circumstances.
Small businesses can also take advantage of 401(k) plans to attract and retain top talent and provide a valuable benefit to their employees. Remember to research, compare, and follow all the IRS regulations when setting up a 401(k) plan for your small business.