401(k) plans can be a powerful tool in promoting financial security in retirement. They are a valuable option for businesses considering a retirement plan, providing benefits to employees and their employers. Anyone with a business with or without employees. can establish a 401(k). The business can be a sole proprietorship, LLC, corporation, partnership, or any other type of legal entity. 

A 401(k) plan is a type of profit-sharing plan under which employees may be allowed to defer a portion of their compensation into the plan on a pretax basis. A 401(k) plan, sometimes called a cash or deferred arrangement (CODA), allows employees either to receive taxable compensation in a current year or to defer taxation by electing to have the employer contribute compensation into a qualified retirement plan (QRP).

Today 401(k plans remain quite popular with large employers and are seen as a helpful way of retaining employees as well as providing them with a way to save for retirement.

History of the 401(k) Plan

In 1978 Congress passes the Revenue Act, which includes a provision that allows employees to avoid being taxed on a portion of income that they decide to receive as deferred compensation, rather than direct pay. The provision becomes Internal Revenue Code Sec. 401(k).   Then in 1981 the IRS issued rules that allowed employees to contribute to their 401(k) plans through salary deductions, which jump-started the widespread roll-out of 401(k) plans in the early 1980s.

Prior to the creation of the 401(k) plan, pensions were the retirement plan standard for just about every employer. A defined benefit plan is what most of us commonly refer to as a ‘pension’. These plans offer guaranteed automatic payouts in retirement based on a formula that usually takes into account your salary and years of service. The longer you work and the more you make, the higher your automatic payouts. Most employers offered defined benefit plans at one point. Social Security is a type of defined benefit plan.

Over the last forty years, most employers have made the shift from defined benefit pensions to the 401(k) plan. To employers, 401(k) plans were seen a lower cost pension option than the defined benefit plan in addition to offering the employees more investment options.

Popularity

According to the U.S. Department of Labor, there are over 650,000 defined contribution retirement plans in the U.S. (560,000+ are 401(k)-type plans), covering more than 100 million total participants (nearly 80 million active). 

Today, 401(k) plans remain quite popular with large employers and are seen as a helpful way of retaining employees as well as providing them with a way to save for retirement. According to The Investment Company Institute (ICI), at year-end 2018, 401(k) plan assets totaled $5.2 trillion and represented 19 percent of the $27.9 trillion in US retirement assets. Research shows that when employers offer 401(k) plans there is a 79% participation rate and the average deferral rate was 6.2% according to the same research from Vanguard.

Types of Plans

The are three primary types of 401(k) plans – the traditional plan, the safe harbor 401(k), and the automatic enrollment 401(k) plan.

Traditional 401(k)

A traditional 401(k) plan offers the maximum flexibility among the three types of plans. Employers have discretion over whether to make contributions for all participants, to match employees’ deferrals, to do both, or to do neither. These contributions can be subject to a vesting schedule (which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time). Annual testing ensures that benefits for rank-and-file employees are proportional to benefits for owners/managers.

Safe Harbor 401(k)

There are several kinds of 401(k) plans that aren’t subject to the annual contributions testing required with traditional 401(k) plans. These are known as safe harbor 401(k) plans and, in exchange for avoiding the annual testing, employees in these plans must receive a certain level of employer contributions. Under the most popular safe harbor 401(k) plan (discussed in this publication), mandatory employer contributions must be fully vested when made.

Automatic Enrollment 401(k)

An automatic enrollment 401(k) plan allows you to automatically enroll employees and place deductions from their salaries in certain default investments unless the employee elects otherwise. This is an effective way for many employers to increase participation in their 401(k) plans.

Note: The traditional, safe harbor and automatic enrollment plans are for employers of any size.

For the self-employed, there’s another plan you may opt for:

Solo 401(k) Plan

A Solo 401(k) plan is a traditional 401(k) plan that covers only one employee, except it is not subject to ERISA like a multiple-employee, employer-sponsored 401(k) plan is. Since the passage of the EGTRRA tax law change in 2002, the Solo 401(k) has become even more popular than the SEP IRA and SIMPLE IRA for self-employed individuals.  However, many of the advantages disappear if non-owner employees are hired.

In order to be eligible for a Solo 401(k) plan, the individual must operate a business with no employees other than the owner(s) or their spouses. The business is not required to be profitable but there must be an active business with the anticipation of profit. Also, the individual can be employed by another business and still adopt a Solo 401(k) though a side business. However, if the individual does not have a business or has a business with employees, he or she will not be eligible.

True Solo 401(k) plans are so popular because it is designed explicitly for small, owner-only businesses that want control over their retirement funds. There are many features of the Solo 401(k) that make it so appealing and popular among self-employed business owners.

• High Contribution Limits: Make annual contributions up to $69,000 for 2024 with an additional $7,500 catch up contribution for those who are at least age 50
• Loan Feature: Eligible to borrow up to $50,000 or 50% of their account value (whichever is less) for any purpose, including paying credit card bills, mortgage payments, personal or business investments, a car, vacation, or anything else. The loan has to be paid back over a five-year period at least quarterly at a minimum prime interest rate (you have the option of selecting a higher interest rate)
• Flexible Contribution Options: Contributions are completely discretionary. You always have the option to try to contribute as much as legally possible, but you always have the option of reducing or even suspending plan contributions if necessary. 

• Roth Type Contributions: Built in Roth sub-account which can be contributed to without any income restrictions; make after-tax contributions allowing you to reach your maximum contribution limit quicker.
• Roth Conversion: Allows for the conversion of pretax 401(k) funds to a Roth. However, the plan participant must pay income tax on the amount converted.

Conclusion

401(k) plans are a valuable tool for retirement savings, offering tax advantages, potential employer contributions, and a variety of investment options. By contributing regularly and taking advantage of employer matches, employees can build a substantial nest egg for their retirement. Despite the restrictions on early withdrawals, the long-term benefits of tax-deferred or tax-free growth make 401(k) plans a key component of a well-rounded retirement strategy. With careful planning and consistent contributions, a 401(k) can help ensure financial security in retirement.