- How They Work
- Advantages and Disadvantages
A 401k plan is a profit sharing plan with a provision that allows participants to contribute a portion of their earnings into the plan on a pre-tax basis. 401k contributions are not subject to current Federal, and in most cases, State income taxes. Tax withholding amounts are automatically reduced to reflect the participant’s 401k contribution.
- -$ 25
- -$ 4
- $ 71
- Pay Period 401k contribution
- Decrease in Federal Income Tax Withholding
- Decrease in State Income Tax Withholding
- Net decrease in take home pay
Taxes are paid on 401k contributions and their investment earnings by the participant when the money is ultimately withdrawn from the plan. Distributions prior to age 59½ are usually subject to an additional 10% excise tax.
For 2021, participants can make 401k contributions up to the lesser of 100% of their compensation or the dollar maximum of $19,500. Those aged 50 and over can contribute an additional $6,500 under the 401k catch-up provisions bringing the total to $26,000.
In addition to the dollar limits, however, contributions made by highly compensated employees may be subject to other restrictions. Highly compensated employees are company owners, their families and non-owners currently earning over $130,000 per year. All other employees are referred to as non-highly compensated employees. Special rules require that the average deferrals of highly compensated employees cannot exceed those of non-highly compensated employees by more than a specified amount. If they do, the employer must either refund a portion of the contributions made by the highly compensated employees or make an additional contribution on the behalf of the non- highly compensated employees.
Participation by non-highly compensated employees is key. The traditional way of encouraging these employees to join a 401k plan is by offering a company matching contribution. In order to receive the match, the employee must contribute to the plan. A typical matching formula would be a match of $0.50 on the dollar for the first 6% of compensation contributed to the plan. Participants who contribute more than 6% of their compensation to the plan would receive no additional matching contributions.
401k plans are popular with both employers and employees. Employers like them because they are the least costly type of plan in terms of employer contributions. The employer is under no obligation to contribute to the plan and administrative expenses can be paid from plan assets. They are popular with employees because it allows them to take control of their own retirement savings.
The drawbacks to 401k plans are that they require more record keeping and administrative services than other types of plans so administrative costs are typically higher. Also, regardless of the incentives, some lower-paid employees will not contribute to the plan which can potentially limit the contributions by and to company owners and other highly-paid employees. Fortunately, both problems are easily addressed and possible solutions are discussed in section titled “Reducing Employer Out-of-Pocket Expenses” and “Safe Harbor 401k Plans” respectively.