One of the most commonly offered retirement plans is a 401(K).There are a couple ways to set up a 401(K), and as the employer, you’ll have a couple options for how to set up the contributions you make.
The types of 401(K)s you can offer are:
- Traditional 401(K): The employer can contribute either (a) a flat percentage of eligible employees’ compensation, (b) matching contributions, based on what the employee contributes, or (c) a combination of these 2. Option (a) is calling a non-elective contribution, and option (b) is called a matching contribution. If you make non-elective contributions, you’re able to change the amount each year. Employee contributions always vest immediately. You can choose to make employer contributions vest immediately, or over time, following a set vesting schedule. When an employee leaves your organization, he or she will only be able to take the money that has vested.
- Safe Harbor 401(K): If you make matching contributions, you can match dollar for dollar up to 3% of an employee’s compensation, and up to 50 cents on the dollar from 3% to 5% of the employee’s compensation. If you make non-elective contributions, you must contribute at least 3% of employees’ compensation. All contributions must be 100% vested immediately.
- Automatic Enrollment 401(K): By default, employees are set up to have a certain percentage deferred from their compensation to contribute to the 401(K), and they have the option to decline this, or to change the percentage. The automatic contribution must be at least 3% of employees’ compensation, and cannot exceed 10%. The employer must make either (a) a non-matching contribution of 3% of compensation for all participants, or (b) matching contributions of 100% of contributions up to 1% of compensation, and 50% for contributions from 1% to 6% of compensation.
- SIMPLE 401(K): Employer contributions are limited to either (a) dollar for dollar matching contributions, up to 3% of compensation, or (b) a non-elective contribution of 2% of compensation for eligible employees.
Unlike a SEP IRA, a 401(K) allows for both the employer and the employee to make contributions. By default, employees will have the option to make traditional contributions, which reduce their taxable income in the year the contribution is made. The employees would not pay taxes on the growth of their investments, but when they take distributions during retirement, the distributions would be taxable income. When the employer is setting up the 401(K), they can choose to allow employees to make Roth contributions. Roth contributions don’t reduce your taxable income when you make them, but when you take distributions in retirement, nothing is taxed. If you’re making contributions throughout your career, most of what’s in your 401(K) will be growth, not the contributions you made, so you can save a significant amount of taxes by making Roth contributions. Note that any contributions made by the employer are non-Roth, so they’ll be taxable when you take distributions, unless you roll them over into a Roth 401(K) or IRA account. You would pay taxes on the amount you rollover.
The maximum contributions you can make to a 401(K) are adjusted each year based on inflation. In 2019, employees can contribute up to $19,000. Employees who are age 50 and older can make additional catch-up contributions of $6,000. The total of employee and employer contributions can’t exceed the lesser of (a) 100% of the employee’s compensation, or (b) $56,000, or $62,000 including catch-up contributions. For a SIMPLE 401(K), employees can contribute up to $13,000, and the catch-up contributions are for workers age 50 and older are $3,000.
Traditional 401(K)s are subject to annual non-discrimination testing. The intent is to make sure that the plan doesn’t disproportionately benefit key employees and highly compensated employees. The Society for Human Resource Management gives an overview of the testing here. Safe harbor 401(K) plans and SIMPLE 401(K) plans are exempt from this testing. If your plan is subject to the testing, you may be able to have your payroll company or a benefits advisor help you administer the plan and perform the required tests.
Finally, you have to file a Form 5500 each year for a 401(K) plan. This reports information about the plan to the IRS, Department of Labor, and employees who participate in the plan. It covers some details about how the plan is operated, as well as some financial data.
Other types of retirement plans to consider: