Understanding the Basics of a 401(k) Retirement Plan for Businesses

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A retirement plan is a great way to help attract and retain employees. But setting up a 401(k) involves a lot of paperwork, including filings with the IRS and establishing a trust for holding the assets. Research the recordkeeping and third-party administration services providers available to you. Focus on firms that can serve your company for the long term.

Tax-Advantaged Savings Plan

What is a 401(k) retirement plan? A 401k retirement plan is an employer-sponsored savings and investment account that allows you to contribute a portion of your salary to long-term investments through automatic paycheck deductions. It’s a popular option for workers, and it can help you build wealth with tax advantages. Investing money in a 401(k) gives it the potential to grow over time, thanks to compounding and the power of investing. It also has the potential to benefit from tax advantages that aren’t available through other types of investments, like a traditional brokerage account. Withdrawals from a 401(k) must be made at least once you’re 59 1/2, or you’ll pay a penalty plus income taxes.

Many employers offer a 401(k) plan as employee benefits; some match your contributions dollar-for-dollar up to a certain percentage of your salary. The right retirement plan can make a big difference in helping employees, including business owners, save for a more comfortable future. Offering a retirement savings plan is an excellent way for small businesses to attract and retain top talent, especially during competitive job markets. The most popular type of tax-advantaged savings account for workplaces is the traditional 401(k) retirement plan, where employees can contribute pre-tax dollars and receive employer matches. Employees can also choose to invest the funds in various mutual fund options, helping their accounts grow over time. In addition to 401(k) plans, many other retirement accounts offer similar tax advantages. Some examples include 403(b) plans for employees of tax-exempt non-profits, 457(b) plans for state and local government workers, and Individual Retirement Account (IRA) plans.

Another benefit of a 401(k) for small businesses is reducing taxable income by contributing a percentage of each paycheck into the retirement account, which can be invested and then withdrawn tax-free once an employee reaches retirement age. This can help a business save on payroll taxes and other employment costs. Other tax-advantaged benefits include flexible spending and health savings accounts, allowing employees to use a portion of their paycheck for out-of-pocket expenses.

Employer Match

In addition to providing tax benefits, 401(k) plans also give employees a financial incentive to work for their business. Employees can have a portion of their paychecks deferred and invested into the company’s 401(k) plan or another qualified retirement plan. These contributions aren’t subject to federal income tax at the time of the contribution, and investment returns are sheltered from taxes until employees take withdrawals in retirement. Many 401(k) plans include employer matching contributions, which the company makes to participants’ accounts in addition to their salary deferrals. This is one of the best ways to boost employee savings. Retirement experts and financial advisors regularly encourage employees to save as much as possible to benefit from the total match amount. The match percentage varies by company and industry, but the average is about 6% of the participant’s salary. Some employers may offer a dollar-for-dollar match, while others may provide a flat-dollar amount per employee or a progressive match that begins at a higher percentage on the first portion of an employee’s salary and declines to a lower percentage on the next portion of their pay. Some 401(k) plans allow for loans, which are repaid to the company typically over five years. This feature isn’t available for all 401(k)s, but it can help participants reach their retirement savings goals.

Defined Contribution Plan

In a defined contribution plan (also known as a DC plan), an employer and, in some cases, the employee make regular contributions into individual pension accounts. The benefits the participant receives upon retirement are based on the amount saved in these accounts and how well the investments performed. Unlike the defined benefit plan, the participant has more control over how the money in these accounts is invested. Employees often choose from a set menu of investment options, including mutual funds and exchange-traded funds (ETFs). Usually, the employer also makes a matching contribution to employee salary deferrals. These plans are less expensive for employers than defined benefit plans, providing an additional incentive for employees to save more. Various defined contribution plans include profit-sharing, money purchase, and 401(k) plans. Some of these plans have terms that encourage loyalty, such as a vesting schedule that requires employees to stay at the company for a certain number of years before they can fully own their employer’s contributions. 

Investment Options

Most 401(k) plans have multiple investment options to choose from. These are typically mutual funds, although some may be exchange-traded (ETFs). These include stocks and bonds and target-date funds that automatically shift your investments to stocks or bonds as you approach retirement. You can also find options like fixed annuities. These are investments in an insurance company that promises to grow your money and send you payments in retirement. But be careful with these options — they often have high fees, including sales charges, annual management fees, insurance fees, rider fees, and surrender fees.

Finally, you can also find diversified stock fund options that invest in many different stocks. These are less volatile than individual stocks and usually track a broad market index, such as the S&P 500. You can also find bond mutual funds that invest in various types of bonds, from short-term to long-term.