401(k) Plans

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A 401(k) is a retirement savings and investing plan that employers offer to attract and retain talent in their organizations. In it’s most basic form, a 401(k) plan gives employees a tax break on money they contribute. Contributions are automatically withdrawn from employee paychecks and invested in funds of the employee’s choosing from a list of available funds. The accounts have an annual contribution limit of $23,500 in 2024 ($30,500 for those age 50 or older). 

If you are not new to the workforce, most people have a good idea on what a 401(k) is, but there are many nuances and differences that make them unique to each employer. The name 401(k)comes from the section of the tax code — specifically subsection 401(k) that established this type of plan. These plans were part of an act in the 1974 called ERISA (Employee Retirement and Income and Security Act), which paved the way for the popularity that 401(k)s are today are today. In years before ERISA, pensions were the most popular retirement vehicle outside of social security.

Employees can contribute money to an individual account by signing up for automatic deductions from their paycheck. Depending on the type of plan you have, the tax break comes either when you contribute money or when you withdraw it in retirement. Many employers will offer a match, which is essentially free money! Now there are caveats, limitations and rules that employers can set up, but as long as you know the basic rules, these are great incentives you should take advantage of! 

If you are new to the workforce or not in the workforce yet, you may ask, how do I get a 401(k)? In simple terms, you get a 401(k) from your employer.  Many employers offer to match a portion of what you save, and the perk that gets all the headlines is the employer match.

If you work for an employer that offers to add extra money into your account based on how much you contribute — such as a dollar-for-dollar or 50-cents-on-the-dollar match up to (as an example), 6% of your contribution amount — this is a great benefit that you should not pass up. If you do nothing else, think about contributing enough to your account to take advantage of free money!

One benefit of a 401(k) is it automates saving for retirement and makes investing a bit easier. You can choose your investments from your plan's selection, or you can let the plan choose for you. Most 401(k)s have what is called a qualified default investment, which basically states if you don’t choose your investments, the plan will pick one for you. In most cases, these are what are called target date funds (TDF). Essentially, TDFs are risk appropriate based on age and tend to become more conservative as time goes on.  They may not be as aggressive or conservative as you view investing, but this is a simple way to invest and puts it more on auto-pilot. Most plans generally have automatically re-balancing, so those percentages stay in line with what you requested. In simple terms, re-balancing avoids becoming too heavy in one asset-class.

Unfortunately, the investment selections in 401(k) plans can be limited. Not all employers offer access to a 401(k) plan. But you can still reap the same tax benefits from the other big retirement savings vehicle such as an individual retirement account also known as an IRA.

Types of 401(k)s

There are several types of 401(k) plans, including the two main kinds: the traditional 401(k) and the Roth 401(k). The traditional (or regular) 401(k) offers an upfront tax break on your savings. Contributions to a Roth 401(k) are made with after-tax dollars, so you don’t get to deduct the money from that year’s taxes. The big break on Roth’s is that the payoff comes later. 

Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, and your money grows tax-free. Let’s assume normal taxes takes 20 cents of every dollar you earn to cover taxes. Saving $800 a month outside of a 401(k) requires earning $1,000 a month — $800, plus $200 to cover the IRS’ cut.

Besides the boost to your savings power, pretax contributions to a traditional 401(k) have another  effect: They lower your total taxable income for the year in which contributions are made. Let’s say you make $75,000 a year and put $10,000 into your 401(k). Instead of paying income taxes on the entire $75,000 you earned, you’ll only owe on $65,000 of your salary. In other words, saving for the future lets you shield $10,000 from taxation.

Once money is in your 401(k), tax shielding takes place and it is not taxable until distribution. This is true for both traditional and Roth 401(k)s. As long as the money remains in the account, you pay no taxes on any investment growth, dividends or interest. 

When you got that tax deduction on the money you contributed to the plan, eventually the IRS comes back around to take a cut. In technical terms, your contributions and the investment growth are called tax-deferred . This basically means, you put off taxes until you start making withdrawals from the account in retirement. At that point, you’ll owe income taxes. Here’s where the Roth 401(k)’s benefits really shine!

Roth 401(k)

If your employer offers a Roth 401(k) – you can contribute after-tax income and your distributions will be tax-free in retirement.  The Roth 401(k) offers the same tax shield as a traditional 401(k) on your investments when they are in the account; you owe nothing to the IRS on the money as it grows. But unlike with qualified withdrawals from a regular 401(k), with a Roth, you owe the IRS nothing when you start taking distributions.

Earlier, we mentioned that, depending on the type of 401(k) plan, you get a tax break either when you contribute or when you withdraw money in retirement? Well, the IRS can charge you income taxes only once. 

You’ve already paid your due because your contributions were made with post-tax dollars.  Any income you get from the account – dividends, interest or capital gains – grows tax-free, and when you withdraw money in retirement, you and taxes are already settled up.

Both the Roth and traditional 401(k)s have rules around withdrawals. There are a few exceptions, but in general, the IRS says you cannot take distributions from your account until age 59½ without running into additional taxes or penalties.

When can I withdraw from my 401(k)

In general terms, you can start to withdraw your savings penalty-free when you reach age 59 ½. Taking out your savings before that time could cost you a penalty of 10% on top of what you’d normally pay in state and federal taxes.

When it’s time to start using your retirement plan savings, be sure to consider the tax implications. In addition, once you turn 72, you typically have to withdraw a minimum amount annually to comply with distribution requirements. However, due to recent changes under SECURE Act 2.0, that is now 73 and phases up to 75 by 2033. 

401(k) plans can be very useful tools in saving for retirement, particularly if you take advantage of features that your plan may offer such as a match, higher contribution limits and Roth accounts to help maximize your savings. The sooner you can start saving in your 401(k) plan, the longer any investment earnings have to produce earnings of their own.

What is a Safe Harbor 401(k)

Before you learn the basics of what safe harbor plans and how they're different, you must understand the government nondiscrimination testing for regular 401(k) accounts.

The government is looking to make sure the 401(k) is to the benefit of everyone in the organization.

The nondiscrimination tests analyze the savings rate of highly compensated employees compared to non-highly compensated employees. For 2023, a highly compensated employee is categorized as a worker earning more than $145,000 annually in the preceding year or someone who owned more than a 5% interest in the business during the previous year.

 With a regular 401(k), a company must pass the nondiscrimination testing every year, but plans that follow the safe harbor framework are assured of fulfilling government requirements. What's more, highly compensated owners don't have to worry about their contributions being capped by ADP testing. 

Safe harbor 401(k) plans can be set up with or without a match. The following are the available 401(k) safe harbor match and contribution options:

• Basic safe harbor: Also known as an elective safe harbor, this plan will match 100% of contributions up to 3% of an employee's compensation and then 50% of an employee's additional contributions, up to 5% of pay.
• Non-elective safe harbor: With these plans, employers make a 3% retirement contribution for all workers, regardless of whether they choose to participate in the plan. 
• Enhanced safe harbor: As another type of elective plan, enhanced safe harbor 401(k) plans meet or exceed what is offered in a basic plan. Typically, they provide a 100% match of up to 4% of an employee's compensation.
• QACA safe harbor: Standing for qualified automatic contribution arrangement, QACA plans feature automatic enrollment that puts aside 3% of a worker’s compensation in the 401(k) plan unless they opt out. There is also a requirement for an auto-increase of 1% per year until the deferral rate reaches 6%. Employers usually match 100% of the first 1% of contributions and 50% of deferrals between 1% to 6% of compensation.