What Does a 401(k) Plan Do?


Employers can enjoy tax benefits and support their employees save for retirement by setting up a 401(k) retirement plan. This 401(k) plan is for all businesses, right from small startups and mid-sized companies to well-established large organizations with huge capital.

What is a 401(k) Plan?

A 401(k) is a retirement savings option that allows both employers and employees to contribute a part of their pre-tax income into their retirement savings. By regularly depositing a small amount from the paystub, one can grow their fund into a considerable sum that can be used after retirement. Since the 401(k) plan contributions are pre-tax, employees can take advantage of the short-term reduced tax burden while their savings grow in the long term in a tax-free environment.

Benefits of a 401(K) Plan

There are significant benefits that both employers and employees can enjoy through a 401(k) plan. These include:

  • Ability to contribute higher amounts compared to a traditional Individual Retirement Account or IRA.
  • Option to deposit up to 25% of the employee’s income to the retirement savings.
  • Significantly high contribution limits for both employers and employees compared to IRA. For instance, if $19,000 was contributed in 2020 to a 401(k) plan, the limit is increased to $19,500 in 2021. While through a traditional IRA, the maximum contribution limit would remain the same for 2020 and 2021 at $6000.

What Are the Different Types of 401(k) Plans?

There are several types of 401(k) plans such as:

Small Business 401(k): Similar to a large business 401(k) plan, the small business 401(k) has provisions for depositing pre-decided contributions from the pre-tax income to the retirement savings. The maximum contribution limits are the same for all businesses regardless of the number of employees. This plan is easy to handle and does not involve any asset management fees. This makes it the best plan for small businesses and startups.

Individual 401(k): This plan is commonly known as a self-employed or solo 401(k) plan. The plan is designed by keeping businesses with a sole-proprietor and self-employed individuals in mind. Hence, the administrative process is simple to handle for individuals. This plan provides huge tax advantages and savings benefits like any other 401(k) plan.

Self-Directed 401(k): This plan provides similar pre-tax savings just like any traditional 401(k) plan with automated salary deductions. The key advantage of selecting a self-directed 401(k) plan is that it allows you to choose where to invest your funds.

SIMPLE 401(k): This plan includes similar provisions to the traditional 401(k) plan and IRA and allows employers and employees to take a loan against the retirement funds. The key benefit of this plan is that it is compliant with the IRS non-discrimination tests. Hence, employers do not need to worry about the annual testing procedure. The only drawback of this plan is that it limits customization and has comparatively lower contribution limits.

Business owners or employers planning to set up a 401(k) plan are recommended to talk to a professional plan provider who can smoothen the process and help you select the best plan for your business goals.

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