A 401(k) plan is an employer-sponsored plan, offered to the employees as a part of their benefits package. In this retirement plan, both the employee and the employer contribute a certain amount to the 401(k) plan, thus allowing tax benefits for both.
A 401(k) plan can help employers to recruit and retain talent, lower their employees’ tax burden and incentivize them to work harder.
But when it comes to 401(k), there are a few different types of 401(k) plans to choose from. And choosing the right is important. However, the problem is that 401(k) plans are complex, and it can be difficult to choose the best type of 401(k) plan for you.
Our goal for writing this article is to make it easy for you to choose. So, we’ll break down the most popular 401(k) plan types and explain how they work; this will help you make an informed decision of choosing the best 401(k) plan for you.
5 Popular Types of 401(k) plans
1) Traditional 401(k) plan
In a traditional plan, the employee contributes a part of their compensation pre-tax to their 401(k) plan. Employers can match a portion of their employee’s contributions. Both the employer and employee 401(k) plan contributions are tax-deferred.
If you want to offer a traditional 401(k) plan to your employees, you have to carry out an annual nondiscrimination test to check whether the contributions do not only benefit the highly compensated employees. The test will compare the average salary deferrals of non-highly compensated employees to highly compensated employees. The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests have to be performed and passed to keep a traditional 401(k) plan.
Who can offer: Private or public employer of any size
Contribution limit:
- By 2021, employees can defer up to $19,500 to their 401(k) retirement plan. Employees of age 50 or more can make an additional catch-up contribution. For 2021, the catch-up contribution limit is $6,500
- For 2021, the total amount of contribution (employer and employee) cannot exceed the annual contribution limit of $58,000, or the limit should be less than 100% of the employee’s compensation.
Contribution requirements: You can either contribute for all participants (even if they don’t contribute), make matching contributions based on an employee’s elective deferral, or both. For profit sharing contributions, the company gets a tax deduction.
Plan requirements: Setting up a traditional 401(k) plan requires you to:
- Write the plan document as per the IRS rules
- Inform the plan details to the participating employees
- Set up a trust for the plan’s assets
- Maintain good 401(k) records
Filing requirements:
- File Form 5500
- Annual reports of the Employee Benefit Plan to report employee benefit plan information
2) Roth 401(k) plan
A Roth 401(k) plan is similar to a traditional 401(k) and a Roth IRA. But with a Roth 401(k), the contributions are made post-tax deductions. So, when the employee retires, the withdrawals made from a Roth 401(k) are generally tax-free.
If you want to offer a Roth 401(k) option, a traditional 401(k) plan must also be offered, where the contributions are pre-taxed. You need to carry out and clear the annual nondiscrimination testing on Roth 401(k) plans.
3) Safe harbor 401(k) plan
This is a special type of retirement plan that clears the nondiscrimination test automatically. This means, unlike a traditional 401(k) plan, you don’t need to pass the ADP and ACP test each year.
However, with a safe harbor plan, the employer has to make contributions to an employee’s 401(k) – irrespective of their compensation, designation, or length of the service.
Who can offer: Any size of business
Contribution limit:
- For 2021, employees can defer up to $19,500 and the additional catch-up contribution limit is $6,500.
- The combined contribution amount (employer and employee) cannot be more than the annual limit of $58,000 for 2021. It should be less than 100% of the employee’s compensation
Contribution requirements: Employer must make a basic/enhanced matching or nonelective contribution
- Basic match: 100% match on the first 3% of deferred compensation + additional 50% for each contribution that is over 3% but under 5%
- Enhanced match: 100% match on the first 4% of deferred compensation
- Nonelective contribution: 3% (or more) of compensation, regardless of employee deferrals
Plan requirements: The employer should give written notice to each eligible employee before each plan year. The written notice should outline plan details and their rights and obligations.
Filing requirements:
- File Form 5500 each year
4) SIMPLE 401(k) plan
This type of retirement plan is best for self-employed professionals or small business owners with 100 or fewer employees. With a SIMPLE 401(k), you don’t have to carry out nondiscrimination tests.
Who can offer: Small businesses with 100 or fewer employees
Contribution limit:
- Employees can only contribute up to $13,500 in 2021
- Employees who are 50 years or older can contribute up to an additional $3,000 for 2021
Contribution requirements: the contributions of both employee and employer are pre-tax. As an employer, you can choose either of the following:
- make a nonelective contribution of 2% of each eligible employee’s pay
OR
- make a matching contribution of up to 3% of each employee’s pay
Plan requirements: To set up a SIMPLE 401(k) plan, you need to:
- Create a written plan approved by the IRS
- Explain the plan to your employees
Filing requirements:
- File Form 5500
5) Solo 401(k) plan
This type of retirement plan is designed for self-employed or business owners with no employee other than their spouse or business partners. Since this plan has only one participant, it is also called a self-employed 401(k), individual 401(k), or solo-k.
Solo 402(k) plan allows employers to make tax-deductible contributions as an employer as well as an employee.
Who can offer: Small business owners, self-employed individuals, sole proprietors, or individuals with no employees except for a spouse or partners
Contribution limit:
- For 2021, you can contribute up to $19,500 or 100% of compensation (whichever is less)
- You can also make an additional profit-sharing contribution of up to 25% of your compensation
- If above 50 years old, you can make an additional $6,500 catch-up contribution for 2021. This contribution should not exceed $26,000 for 2021
- The total contribution (excluding catch-up contributions) cannot exceed $58,000 in 2021
Contribution requirements: You can contribute as both the employee and the employer.
Plan requirements: You need to have an Employer Identification Number (EIN) and should meet the eligibility requirements.
Filing requirements:
- File Form 5500-EZ
Now that you know the different types of 401(k) plans, you can choose the best retirement plan that fits your needs and your employees’ retirement planning needs.
About the author:
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He regularly writes for blogs at MoneyForLunch, Biggerpocket, SocialMediaToday, NuWireInvestor & his own blog for Self Directed Retirement Plans. If you need help and guidance with traditional or alternative investments, email him at rick@sdretirementplans.com or visit www.sdretirementplans.com.
