What Makes the 401(k) So Popular?
Updated: Jun 29, 2021
What Makes 401(k) Plans So Popular?
The answer to this question could be summarized with one word…flexibility.
The 401(k) plan is one of the most popular forms of qualified retirement plans because it offers a robust set of customizable features and elements to benefit the company sponsoring the plan and its employees. Flexibility is significant because it translates to customization and in today’s world where we can customize our sandwiches, our frozen yogurt, and even our sneakers to meet our needs, we should be able to customize our retirement plan too. Let’s take a look at what 401(k) plans offer, and the options available to plan sponsors.
The 401(k) plan is less expensive than other types of qualified retirement plans, and employer contributions aren’t required like they are in other plan types. Plus, employees are able to reduce their taxes through salary deferrals into the plan, and employers may receive tax incentives for sponsoring a plan.
Variety of Investments
401(k) plans allow you to choose from a myriad of investment companies with a variety of different platforms and fund selections. You can even choose between employer-directed or participant-directed investments.
With a 401(k) plan, you can utilize eligibility requirements to exclude or include certain employees from the plan. There are a few minimum requirements set forth by ERISA that employers must comply with, but beyond those you have great flexibility in choosing the age, years of service, and hours worked requirements.
On average, 30% of employees don’t participate in their company’s 401(k) plan. Adding automatic enrollment to your plan can increase the participation rates in your plan and help employees save for retirement.
Download our Guide to What Makes the 401(k) Popular
Basic Automatic Enrollment (ACA):
Employees are automatically enrolled in the plan unless they opt-out. The plan document specifies the deferral percentage. Employees can opt-out, or select to change their deferral percentage and contribute a different percentage of pay.
Eligible Automatic Contribution Arrangement (EACA):
Uniformly applies the plan’s default deferral percentage to all employees after giving them the required notice may allow employees to withdraw automatic contributions, including earnings, within 90 days of the date of the first automatic contribution
Qualified Automatic Contribution Arrangement (QACA):
Uniformly applies the plan’s default deferral percentage to all employees after giving them the required notice. Meets Safe Harbor provisions. The default deferral percentage starts at 3% and gradually increases to 6% with each year that an employee participates. The default percentage cannot exceed 10%. Required employer contributions. You must pick either: matching contribution: 100% match for elective deferrals that do not exceed 1% of compensation, plus 50% match for elective deferrals between 1% and 6% of compensation; or nonelective contribution: 3% of compensation for all participants, including those who choose not to participate in the plan. Employees must be 100% vested in the employer’s matching or nonelective contributions after no more than 2 years of service. The plan may not distribute any of the required employer contributions due to an employee’s financial hardship
*Information Sourced from the IRS Page Covering Automatic Enrollment.
Select Entry Dates
401(k) plans have modifiable entry dates. There are a few exclusions and minimum requirements that ERISA sets forth, but as long as you comply with these standards you can pretty much determine your own dates for eligible employees to enter the plan. We have clients who offer entry dates as frequently as each payroll period or as infrequently as semi-annually.
Optional Employee Deferrals
In a 401(k) you must give your participating employees the ability to voluntarily defer a portion of their compensation into the plan before federal and state taxes are calculated. These deferrals out of the employees’ compensation are then deposited into the 401(k) plan where they grow tax-deferred. Employees are not required to participate in the 401(k) plan.
Automatically increase employee deferrals. Employees can always opt-out but this increases their deferral percentage automatically, typically on a yearly basis, which helps them save more for retirement.
Employers are increasingly adding a Roth 401(k) feature to their plans. With a Roth, the deferrals are after-tax. If you elect to offer a Roth option, then employees have the option to make pre-tax deferrals to the 401(k) or after-tax Roth deferrals, or both!
Optional Employer Matching & Contributions
Employer contributions and matching are not required in a 401(k) plan, however, many employers choose to match employees’ elective deferrals as an added benefit to their overall compensation package. Please note that in some cases if the plan fails testing, mandatory contributions to employees may be required. Safe Harbor 401(k) plans forgo much of this testing but with a Safe Harbor 401(k), employer contributions are required.
Distributions and Rollovers
Employees can take their vested account balances with them when they leave the employer. This is appealing to employees because the funds can be taken in the form of a distribution or a rollover. Distributions before age 59 ½ are taxed and penalized. However, rollovers can be rolled into the employee’s new 401(k) plan or into an IRA, penalty-free.
Employee deferrals are always 100% vested, meaning, employees can take that money with them if they leave the company. Employer contributions, on the other hand, are subject to a vesting schedule chosen by the employer. Employers put vesting schedules in place in an effort to retain employees. If the employee leaves and isn’t fully vested in their 401(k) account, then the employee “forfeits” the unvested portion of the money. Forfeited money is distributed into a forfeiture account and can be used to distribute to other employees or pay for plan expenses. There are minimum vesting requirements. However, there is room for the employer to customize vesting.
Other Types of 401(k) Plans
Safe Harbor 401(k) Plans
A Safe Harbor plan is an extension of the 401(k). Employers who elect to offer Safe Harbor plans can bypass some of the required discrimination testing for the traditional 401(k). In order to bypass this testing, employer contributions must be 100% immediately vested and employers must make a required minimum contribution. The required minimum contribution is:
An employer match equal to 100% on the first 3% of employee deferrals and 50% on the next 2% contributed or
A 3% (of gross compensation) non-elective contribution to all eligible employees even if they don’t defer.
Owner Only 401(k) Plan
An owner only 401(k) is designed for companies with one employee. This plan covers only the owner and their spouse. The same annual limits in a traditional 401(k) plan apply. This type of plan is only available to companies with one employee.
Add more benefits in addition to a 401(k) Plan
Profit Sharing Contribution
In addition to sponsoring a 401(k), you can also make a profit sharing contribution to your plan. This is a discretionary amount that is given to eligible employees on a yearly basis and it is not determined by the actual profits of the company. A formula is determined by the employer and eligible employees receive a contribution based on this formula. These contributions can be allocated in numerous ways such as prorate based on compensation, based on age and/or years of service or based on groups.
Defined Benefit Plans
A defined benefit plan can be offered in conjunction with a 401(k) plan to maximize retirement benefits. Employers can shelter more income from taxes by sponsoring a defined benefit and defined contribution plan. Combined, these plans allow for higher contributions and larger tax deductions.
As you can see, the 401(k) plan offers a plethora of design options that can accommodate a company of any size, which is why it is so popular among today’s employers.