401(k), The Preferred Vehicle for Retirement Savings

A 401(k) retirement savings plan is one of the most desirable fringe benefits a small business can offer. For a business owner, it can help strengthen a company’s position when competing for top talent. It can also be structured to help retain employees once they are hired. For employees, a company-sponsored 401(k) plan offers an excellent way to build a retirement nest egg through tax-deferred savings.

In Brief

A 401(k) plan allows each employee to set aside part of his or her salary, subject to certain limitations, in a separate account to grow on a tax-deferred basis. Participants have the flexibility to choose from among a variety of funding options offered by the plan. Employers may contribute to employee accounts by matching a percentage of their employees’ contributions. Withdrawals usually occur at retirement—when plan participants are more likely to be in a lower income tax bracket.

Possible Advantages

The benefits of a 401(k) plan are numerous and may include some, or all, of the following:

Pre-Tax Contributions

Employee contributions are typically made on a pretax basis, subject to certain limitations. By lowering their taxable salary or wages, plan participants are able to lower their income tax for each year they participate.

Employer Matching Contributions

Some employers match contributions up to a certain percentage. For instance, with a 50% match, an employer would contribute $0.50 for every $1.00 an employee contributes. The advantage of matching contributions generally depends on the level of the match and the employer’s vesting requirements.

“Vesting” refers to an employee’s right to the funds in his or her account. An employee’s contributions, and the earnings on those contributions, are fully vested from his or her start in the plan. An employer’s matching contributions vest according to a schedule that usually depends on the employee’s length of service. Thus, an employer can arrange the vesting schedule to reward and retain employees by fully vesting plan participants after, say, five years.

Variety of Funding Options

Plan participants may select from a variety of funding options. Most plans also allow employees to change their funding choices periodically to reflect their individual needs and goals.

Tax-Deferred Earnings

Earnings on any contributions accumulate on a tax-deferred basis. This includes earnings on matching contributions made by employers.

After-Tax Contributions

Many plans also allow employees to make after-tax contributions, subject to certain limitations. While these contributions do not lower the current year’s income tax, as do pre-tax contributions, they also accumulate earnings on a tax-deferred basis.

Restrictions

As with all retirement plans, 401(k) plans have certain limitations:

Limits for Highly Compensated Employees (HCEs)

The contributions of HCEs may be limited if lower paid employees do not contribute a sufficient amount. Every year, plan administrators must perform certain “top-heavy” tests to determine the maximum amount HCEs may contribute.

Taxation at Withdrawal

Plan participants are subject to income taxes for pretax contributions when they withdraw the funds. However, after-tax contributions are not subject to further taxation when withdrawn.

Early Withdrawal Penalty

Withdrawals prior to age 59½ may occur only under certain circumstances and, when allowed, may be subject to a 10% early withdrawal penalty. A 401(k) plan offers advantages for both employer and employees. For business owners, it can help attract and retain desirable employees. For employees, a 401(k) plan, when combined with income from other sources, such as Social Security, a pension, and personal savings, can help them achieve their retirement objectives. It’s no wonder that, for many, 401(k) plans have become the preferred vehicle for retirement savings.

To learn more about how a 401(k) might be right for you, schedule an appointment with one of our financial professionals.