Types of 401(k) Plans: Traditional, Safe Harbor & More
The U.S retirement market is worth over $33.7 trillion. Approximately 6.5 trillion of that is in 401(k) employer-sponsored retirement plans. This figure stands for more than 20% of the entire retirement market.
Unfortunately, a recent survey shows that more than ⅔ of workers don’t understand how 401(k) retirement savings plans work. If you fall into this bracket, don’t fret. In this article, you’ll learn everything you need to know about 401(k) plans. We have a lot to unpack, so let’s get started.
Table of Contents
What Is a 401(k) Plan?
The 401(k) retirement plan gets its name from an Internal Revenue Service (IRS) code. This code specifies the rules for this type of account: section 401 subsection K.
In simple terms, the government allows employers to offer retirement plans with certain tax breaks. This encourages employees to put savings into their retirement accounts. In fact, these tax advantages are one of the main benefits of opening a 401(k) plan.
These plans are often thought of as employee contributions. But the regulations actually consider them as employer contributions.
Plus, they work great for small businesses. They boost employee morale, ensure future financial security, and reduce employee turnover. The tax credits can also reduce the tax liability of a business.
Pre-tax dollars fund most 401(k) plans. A 401(k) plan can also be a part of a profit-sharing plan. Profit-sharing plans are suitable for businesses of any size.
How 401(k) Plans Work
When you open a 401(k) account, you’ll need to specify an amount or a percentage of your paycheck that will fund the account. You can also choose the investment options that you want to use with these funds. Most employers have 2 investment options for contributions: mutual funds and exchange-traded funds. This way, you’re saving money and investing for a higher return.
401(k) plans let employees grow tax-deferred investments. This means they don’t pay income taxes until they withdraw the money from their accounts upon retirement.
Types of 401(k) Plans
Types of 401(k) contributions vary depending on whether the retirement funds get taxed before or after making the savings. They also vary depending on the number of participants involved. Different 401(k) plan types include:
- Traditional 401(k) plan
- Safe Harbor 401(k) plan
- SIMPLE 401(k) plan
- Roth 401(k) plan
- Solo 401(k) plan
Let’s take a look at each of these individually.
Traditional 401(k) Plan
The traditional 401(k) plan was the only defined contribution plan available when 401(k) plans became available in 1978. With a traditional 401(k) plan, the contribution amount gets deducted after taxing the income. As a result, the earnings are tax-deferred. Basically, you can make pre-tax elective deferrals through payroll deductions.
Many large and small business owners go for these pre-tax contributions. It allows them to offer retirement benefits for eligible employees. As a rule of thumb, employees wishing to be in a lower marginal tax bracket after retirement opt for a traditional 401(k) plan.
Your savings are not taxed until you decide to cash out, which is often during retirement. Also, this will be at ordinary income rates. This reduces your income taxes and lets you put paying them off until you’re in a lower tax bracket.
The advantages of a traditional 401(k) plan include flexibility and the opportunity for a mutual investment account. You also get the ability to tweak employer contributions each year, plus high levels of salary deferrals on behalf of employees. This 401(k) plan is best for public and private companies with 20 or more employees, as it includes both the employee’s and employer’s contribution.
Traditional 401(k) Plan Limitations
The maximum amount you can contribute annually towards a traditional 401(k) is $20,500. In a traditional 401(k) plan, the employer can make contributions on behalf of all participants via matching contributions. These are tax deductible.
Traditional 401(k) Plan Tests
Businesses that choose the traditional 401(k) plans must conduct yearly nondiscrimination tests. This ensures contributions aren’t only favorable for high-earning employees. The test consists of a comparison of the average compensation deferrals. Highly-compensated employees have their deferrals compared to those employees with smaller compensations.
It’s also necessary to pass the Actual Contribution Percentage (ACP) and the Actual Deferral Percentage (ADP) tests.
Safe Harbor 401(k) Plan
Safe Harbor 401(k) is the most popular 401(k) retirement plan type. In fact, these plans constitute more than 68% of all 401(k) plans. Simply put, it is the most common type of contribution that an employer makes to an employee’s 401(k) account. It’s a predetermined amount that usually represents a percentage of an employee’s salary.
The most common form of Safe Harbor is a match, meaning that an employer can only contribute if the employee does so. Another form of Safe Harbor is a non-elective. In this plan, the employer commits to make contributions to the employee’s 401(k) account regardless of whether they contribute to it or not.
Benefits of Safe Harbor 401(k) Plan to the Employee:
- It is basically a source of free money
- It provides an incentive to save more
- It provides immediate vesting because an employee is entitled to the employer’s contributions
Benefits of Safe Harbor 401(k) Plan to the Employer:
- You’re exempted from annual compliance testing
- Deduct employer contributions from corporate taxes
- A Safe Harbor 401(k) employer contributions plan will boost employee happiness and help retain talent
SIMPLE 401(k) plan stands for the Savings Incentive Match Plan for Employees. Small business owners with 100 or fewer employees offer these retirement savings plans. Both the employer and the employees contribute to this plan.
The SIMPLE 401(k) plan is good for small businesses and firms that aim to expand in the future due to a 2-year grace period for exceeding 100 employees. This allows the business time to determine which retirement plan will best suit its business model.
Requirements for setting up a SIMPLE 401(k) retirement plan include:
- Not having an existing account
- Having less than 100 employees
- Filing the Form 5500 each year
Employee Contribution Limits
The annual employee contribution limit as of 2022 is $14,000. An eligible employee that is older than 50 can make catch-up contributions of $3,000.
Employer Contribution limits
Limited to a dollar-for-dollar match up to 3% of the employee’s pay or a 2% non-elective contribution for every eligible employer.
Roth 401(k) Plan
The Roth 401(k) plan is a post-tax deductible plan that arrived in 2006. It’s named after William Roth, a former U.S. Senator of Delaware. He was the primary sponsor of the 1997 legislation that passed Roth IRA.
Tax-free Roth 401(k) employer contributions are the complete opposite of traditional 401(k) plans. The employee contributions towards a Roth 401(k) plan aren’t tax-deferred. They’re made with after-tax dollars.
Your contributions won’t lower your current income tax, but your savings will continue to grow tax-free throughout the years with a Roth plan. Plus, you won’t have to pay taxes on your withdrawals or your investment earnings when you retire.
Overall, the after-tax dollars Roth 401(k) plan is great for those who believe they’ll be in a higher tax bracket after retirement. It’s solid for both highly-compensated employees and younger employees.
A business of any size can offer Roth 401(k) plans. The annual contribution limit for Roth accounts is $20,500. Employees older than 50 can make an additional catch-up contribution of $6,500.
Solo 401(k) Plan (Not for Employees)
As the name suggests, this is a 401(k) retirement savings plan for self-employed individuals. It’s a great plan for small businesses and sole proprietors. The Solo 401(k) allows you to fund an account as both an employee and an employer, and then reap the tax-related benefits of both sides. This plan is also called solo-k, self-employed 401(k), or individual 401(k).
The solo 401(k) plan lets the employer make both employer and employee contributions. Doing so helps maximize retirement contributions and business deductions.
Solo 401(k) Plan Limitations
Employer-employee contributions can’t exceed $61,000 annually. They also can’t be less than 100% of the employee’s compensation. You can only contribute up to $6,000 in a traditional Individual Retirement Account (IRA) or $7,000 if you’re 50 or older.
Even better, you can deduct your contributions from your tax returns. That makes this plan an excellent option for self-employed people looking to reduce their income taxes.
Eligibility requirements for a solo tax-deferred 401(k) Plan include:
- Being self-employed
- Generating active self-employment income
- Not having full-time employees (except a business partner or spouse)
- Being the only participant in the business
With a solo 401(k) account, you can contribute up to 100% of your earned income up to $19,500 as an employee. You can also make extra contributions based on the total compensation as an employer. According to the IRS, you can contribute up to 25% of the compensation defined in your solo 401(k) plan.
Some Solo 401(k) Benefits Include:
- Generous tax benefits for small business owners. The contribution limit is high, and if you take advantage of it, you can reduce your taxable income.
- You can borrow against your solo 401(k) funds. The loan limit is $50,000, 50% of the total funds, or whichever is less.
- No taxes or penalties are associated with the loan for a small business owner. However, you’ll still have to pay interest.
Cons of a Solo Tax-Deferred 401(k) Plan Include:
- A solo 401(k) account has more complex management than any other account. As you can imagine, there are many things you can do with the account, so it makes sense that it’s a little challenging to set up.
- You might encounter more fees when using the solo 401(k) account compared to other retirement accounts. This is partly thanks to the extra administrative work required.
The 401(k) is an employer-sponsored retirement plan with numerous benefits for both the employee and the employer. As a small business owner, consider the size of your company and how much you can afford in terms of management fees and contributions. After you’ve done that, you can move on to choosing a 401(k) plan.
Some plans involve more expenses, such as brokerage fees, which might affect your profits. Also, different plans may include lower employer contribution thresholds. If you’re still dubious about the best plan for your particular needs, consult a financial advisor. And always proceed with caution.
FAQ on 401(k) Plans
What Happens to Your 401(k) When You Quit?
Your 401(k) account is tied to your employer, so you won’t be able to contribute to it when you quit or leave your job. However, the funds available in the account are yours to keep. You can choose to leave the retirement plan funds to the employer, cash out the balance, or roll the previous plan to the new account.
How Much Should I Put in My 401(k) Plan per Paycheck?
Many financial experts agree that 10% to 20% of your salary is a good amount to set aside for retirement. But the higher the amount, the better. It comes down to your personal preferences and individual goals. Weigh your salary and determine the amount you’re comfortable setting aside for the future.
How Long Can a Company Hold Your 401(k) Plan After You Leave?
A company can hold your 401(k) plan for as long as you want—unless you decide to roll to another plan or take cash out.
However, you must have $5,000 or more for the company to continue managing your account. If you have less than $5,000, the employer can keep the funds for up to 60 days. Then they will cash out your funds via a check or roll over funds to a retirement account or your current 401(k).