Summary: 401(k) plans are the most popular form of employer-sponsored retirement plan in the US.
401(k)
A 401(k) plan is a type of retirement plan that provides employees with tax advantages while helping them save money for retirement.
Officially introduced in 1980, 401(k) plans were meant to supplement traditional workplace pension plans (often called defined benefit plans). However, over the past four decades, 401(k) plans have become more popular than pension plans as employers have shifted the responsibility and risk of saving for retirement to employees.
Named after Section 401(k) of the U.S. Internal Revenue Code, the 401(k) plan is an employer-provided defined contribution plan. Unlike traditional pension plans, a defined contribution plan requires employees to contribute a fixed percentage of their salary. Additionally, an employer may provide additional contributions to the plan, benefiting each employee’s retirement plan account.
401(k) plans are the most common employer-sponsored defined contribution plan in the United States, holding USD 7.4 trillion in assets as of December 31, 2023. Just over one-third of working-aged Americans have a 401(k) offered through their employer, compared to 13.5 percent having a traditional defined benefit plan.
A 401(k) plan can either be administered directly by an employer, or via a professional co-employer, as a PEO retirement plan.
How does a 401(k) plan work?
The most common type of 401(k) plan is a traditional 401(k) retirement plan. However, in recent years, Roth 401(k) plans have become more popular, with the majority of employers offering a Roth component in their 401(k) plans. Each type of 401(k) plan has its own tax advantages.
Here’s a closer look at each.
Traditional 401(k) plan
A traditional 401(k) plan allows employees to contribute to the retirement plan on a pre-tax basis, meaning that any contributions directly reduce their taxable income. In other words, employee contributions are deducted from the employee’s gross income, which is referred to as a tax deduction. So, ultimately, these contributions are subtracted from the employee’s paycheck before income taxes are deducted, reducing the amount of compensation on which employees are taxed.
Let’s look at an example:
Say an employee makes $75,000 annually. If that employee contributes \$8,000 to a traditional 401(k) plan on a pre-tax basis, then that employee’s annual salary is reduced by \$8,000, resulting in a taxable income of \$68,000. This employee would have income taxes withheld from the $68,000, not the $75,000.
No taxes are due on the 401(k) plan contributions, and employees do not pay any taxes on investment growth as long as the money stays in the 401(k) plans. However, when an employee withdraws from their 401(k) plan, the contributions and any interest earned on those contributions are taxable as ordinary income.
Roth 401(k) plan
In 2006, Roth 401(k)s entered the scene. Unlike a traditional 401(k) plan, employee contributions to a Roth 401(k) plan are made after income taxes are withheld. So, the employee does not enjoy a tax deduction in the year the contribution is made.
Let’s look at the same example as above, except applying it to a Roth 401(k) plan. Say an employee makes $75,000 annually. If that employee contributes $8,000 to a Roth 401(k) plan on an after-tax basis, then that employee’s annual salary is not reduced. This employee would have income taxes withheld from the $75,000.
When the employee takes a withdrawal from their 401(k) plan, the employee does not pay taxes on the withdrawn contributions (and any investment earnings).
Not all employers offer a Roth 401(k) plan. Employees should check with their human resources department to learn more about this option.
What are some other types of employee contributions?
An employer’s 401(k) plan may offer additional types of contributions, including:
- Catch-up contributions: Catch-up contributions are additional employee contributions that can be deducted from the employee’s salary (often called salary deferrals) if the employee is at least 50 years old. Most employers permit catch-up contributions, but not all. Employees should check with their human resources department to learn more about this option.
- After-tax contributions: Similar to Roth contributions, after-tax contributions are made to a 401(k) plan (if permitted by the plan) after income taxes are withheld. However, unlike Roth contributions, higher contribution limits apply to after-tax contributions, and any gains earned on these contribution types are subject to taxes when distributed. We discuss contribution limits below.
- Rollover contributions: Rollover contributions occur when an employee wants to move retirement plan money from another company-sponsored retirement plan (such as one with a former employer) or an individual retirement arrangement (IRA). Depending on the employer’s plan, these rollovers may be treated as traditional pre-tax or Roth 401(k) contributions.
Are there limits to how much employees can contribute?
The Internal Revenue Service (IRS) establishes certain 401(k) contribution limits for employees, which may be adjusted annually.
For 2024, employees can contribute up to $23,000 of their salary to either a traditional or Roth 401(k) plan. Additionally, this amount can be split between the two if the employer’s plan permits Roth contributions. For instance, if Roth contributions are allowed, employers may choose to contribute $13,000 to the pre-tax portion of their 401(k) plan and $10,000 to the Roth portion of their 401(k) plan, splitting their contributions between the two options.
If employees are 50 years or older, they can contribute an additional $7,500 catch-up contribution, for a total of $30,500 ($23,000 + $7,500 = $30,500).
What are the different types of employer contributions?
Employers may contribute to 401(k) plans on behalf of employees. However, not all 401(k) plans are the same, so employees should check with their human resources (HR) department to understand any employer contributions to their retirement plan.
Matching contributions
Matching contributions are common employer contributions permitted in some 401(k) plans. These contributions “match” a certain percentage of the employee’s traditional or Roth contributions.
For example, a plan may permit the employer to contribute $1 for every dollar up to 3% of what the employee chooses to defer and then $0.50 for every dollar up to 2% of what the employee chooses to defer. This results in an additional 4% contribution to the employee’s 401(k) plan.
Unlike traditional or Roth contributions, matching contributions are often subject to a vesting schedule, meaning that the employee gains ownership of these contributions over their employment with the company. Employees are immediately vested in their own contributions made to the 401(k) plan.
Here are some examples of common vesting schedules:
Years of Service | Cliff Vesting | Graded Vesting |
0 | 0% | 0% |
1 | 0% | 0% |
2 | 0% | 20% |
3 | 100% | 40% |
4 | 100% | 60% |
5 | 100% | 80% |
6 | 100% | 100% |
Depending on the plan, the employer may have discretion in making these contributions, whereas other plans make these contributions mandatorily.
Other employer contributions
In addition to matching contributions, employers may make other contributions to the 401(k) plan if the plan document permits. For example, these include:
- Profit-sharing contributions: Depending on the plan, an employer may make a profit-sharing contribution, which is also called a nonelective contribution. To receive these contributions, employees do not have to contribute to the 401(k) plan, like matching contributions.
For example, the employer may contribute 3% of the salary for all employees participating in the plan, whether the employees contribute to the 401(k) plan or not. Additionally, a plan may permit the employer to contribute a certain amount to the plan at the end of the plan year. Often, these end-of-year contributions are discretionary. - Qualified matching contributions: Often abbreviated as QMAC, a qualified matching contribution is a special type of employer contribution used to correct certain plan compliance issues. Unlike other employer contributions, employees are fully vested in these contributions, meaning that they have 100% ownership of these QMACs when made.
- Qualified nonelective contributions: Similar to QMACs, a qualified nonelective contribution (or QNEC) is another special type of employer contribution used to correct certain plan compliance issues. Employers are also fully vested in these contributions, meaning that they have 100% ownership of these QNECs when made.
Employees should check with their HR department to learn more about these employer contributions.
Are there limits to how much an employer can contribute?
Similar to employee contributions, the IRS also limits how much employers can contribute to 401(k) plans. For example, the total amount that employees and employers can contribute to the plan is $69,000 for 2024. If the employee is 50 or older, this limit is increased to $76,500 for 2024.
So, what does this mean?
Suppose an employee who is younger than 50 years old contributes $23,000 in 2024 to the 401(k) plan. If that is the case, then the employer can contribute up to $46,000 ($23,000 + $46,000 = $69,000).
If an employee is 50 years or older and making catch-up contributions, the employee is limited to $30,500 in contributions, and the employer is limited to $46,000 in contributions ($30,500 + $46,000 = $76,500).
How do 401(k) withdrawals work?
401(k) plans are supposed to provide for employees’ retirement. So, most of the 401(k) distribution rules focus on what happens if an employee withdraws funds from their 401(k) plan before or after retirement. However, the IRS does acknowledge that “life happens.” The 401(k) distribution rules do take other life events, such as death or disability, into account.
Although there are numerous opportunities for employees to take a 401(k) plan distribution, here are some of the most common types of distributions.
Withdrawing before and after age 59½
Most plans permit employees to withdraw their 401(k) funds before they turn 59½. However, if an employee chooses to do so, they will likely face a 10% early distribution penalty in addition to any taxes owed on traditional 401(k) contributions. If an employee is 59½ or older, they may start taking penalty-free distributions from their plan (whether they have reached retirement age or not).
This penalty is not owed if the employee takes a hardship distribution and is under age 59½.
Additionally, if an employee retires or loses their job at age 55 or older, but not yet 59½, then the employee can avoid this 10% early withdrawal penalty if the employee chooses to take a distribution from their 401(k) plan.
Withdrawing upon death or disability
If an employee dies or becomes totally disabled, then they (or their beneficiaries) may take a 401(k) plan distribution without paying the 10% early retirement penalty. Additionally, if the employee is not fully vested in their employer contributions, these contributions immediately become 100% vested upon death or disability.
Other withdrawal opportunities
Other common types of 401(k) distributions include:
- Minimum required distributions: Employees don’t need to start taking 401(k) plan distributions immediately upon retirement. In most circumstances, employees can leave their money in the retirement plan, letting it continue to grow. However, the IRS does require that employees start taking “minimum required distributions” when the employee turns age 73 (if born between 1951 and 1959) and age 75 (if born in 1960 or later). The amount of the minimum required distribution is based on the employee’s life expectancy.
- Plan loans: Depending on the plan document, employees may also take a 401(k) plan loan if they apply and meet certain criteria. A plan loan is not subject to income or early withdrawal penalty taxes. However, it is borrowed money subject to an interest rate, just like any other loan. Employers typically require repayments (the principal amount borrowed plus interest) to the plan directly from an employee’s paycheck,
- Hardship distributions: Depending on the plan document, employees may also take a 401(k) hardship distribution due to an “immediate and heavy financial need,” such as medical care expenses for the employee or their immediate family or an amount needed to avoid foreclosure on the employee’s home. The hardship distribution is limited to the amount necessary to satisfy the financial need. The 10% early distribution penalty does not apply to hardship distributions; however, they are subject to income taxes.
Conclusion
401(k) plans help companies attract and retain top talent while helping employees save for retirement with powerful tax benefits. However, not all 401(k) plans are created equally. This is why it’s essential for employers to understand the options, oversight, and management of these plans so that they can maximize employer and employee contributions.
If you are interested in how a PEO might help you manage your 401(k) plans, get in touch with our Remote People PEO broker service.
FAQ
What is a 401(k) plan?
A 401(k) plan is a type of retirement plan that provides employees with tax advantages while helping them save money for retirement.
What is the difference between a traditional 401(k) plan and a Roth 401(k) plan?
A traditional 401(k) plan allows employees to contribute to the retirement plan on a pre-tax basis, meaning that any contributions directly reduce their taxable income. Employee contributions to a Roth 401(k) plan are made after income taxes are withheld.
For other types of retirement plan, check out our 401(a) and 401(k) vs 403(b) guides.
Authors:
Jennifer is an HR and employment compliance specialist with more than 20 years experience as a transactional attorney, focused on employee benefits, retirement plans and health plans.
