Types of 401(k) Plans: A Beginner’s Guide

The 401(k) is one of the primary vehicles Americans use to invest for retirement. But if you ask many participants how their plan works or what it invests in, you might get some vague answers or shoulder shrugs. Most forward-thinking people know it’s important to save for retirement, but have questions about how, where, and when. A 401(k) is a good place to start, especially since the employer is in charge of setting it up and handling administration costs. However, you’ll still need to understand the differences between varying types of 401(k) plans. Yes, there’s more than one type and they affect both individuals and the businesses administering them differently.

If you need assistance with your finances, work with a professional financial advisor from Good Life Financial Advisors of Mt. Pleasant. We’re ready to help create a personalized plan for your specific needs.

Traditional 401(k) Plan

The traditional 401(k) plan is the most popular type. A traditional 401(k) is set up by an employer who wishes to provide a retirement service for their employees. 401(k) plans are investment accounts that primarily invest in mutual funds (with some exceptions) and charge small quarterly fees. The employer pays to administer the plan, but they receive a tax break if certain requirements are met.

The biggest benefit of using a traditional 401(k) is money used to fund the plan isn’t taxed. In most cases, you’ll request a certain percentage of your salary be retained for your retirement account (5% to 7% is a good starting place). The money you put into your traditional 401(k) will be removed from your taxable income for the year.

For 2021, the maximum contribution limit for a 401(k) is $19,500 or $26,000 if you’re 50 or older. Note that this is only the individual contribution. Anything your employer contributes doesn’t count toward this limit, only the upper total limit of $64,500. That’s right, if your employer is feeling generous, you can put away $64,500 in tax-deferred funds each year. However, funds deposited into a 401(k) can’t be touched without penalty until age 59.5.

Roth 401(k) Plan

A Roth 401(k) is the cousin of the Roth IRA, which changes when the tax break is received for retirement savers. Just like with the IRA, a Roth 401(k) is funded with after-tax dollars, so you can’t write off any contributions when you file with the IRS. However, once your account is funded, it grows completely free from taxation. You’ll keep 100% of your dividends, capital gains distributions, and price appreciation profits. Roth 401(k) plans are somewhat rare since an employer must include them in offerings with a traditional 401(k). Employers can have traditional 401(k) plans by themselves, but a Roth 401(k) must be offered in tandem with a traditional.

Roth 401(k)s have a few advantages over traditional 401(k)s. One of the biggest is the ability to withdraw your contributions at any time without penalty. Now, this doesn’t mean you can empty the account at any time. Any gains you’ve accumulated on your investments cannot be withdrawn without penalty until 59.5. But the contributions, or the original deposits made to the account, can be withdrawn at will. For example, if you contribute $10,000 per year to your Roth 401(k) and have a $75,000 balance after five years, you can withdraw the $50,000 in contributions you made but not the extra $25,000 in gains.

SIMPLE 401(k) Plan

SIMPLE stands for Savings Incentive Match PLan for Employees. The IRA version of this type is more common than the 401(k). But the SIMPLE 401(k) can be a useful vehicle for small companies and start-ups. Only businesses with 100 or fewer employees can administer a SIMPLE 401(k).

A SIMPLE 401(k) has a few differences from the Roth and traditional models. For starters, employee contributions max out at $13,500 in 2021. That’s a $6,000 drop! So why would anyone choose a SIMPLE 401(k)?

For employers, the SIMPLE 401(k) isn’t subject to nondiscrimination tests, which are regulatory compliance checks made by the IRS to ensure that the wealthiest employees at a business aren’t receiving an unfair advantage in the plan.

But employees also benefit as well. Despite the lower contribution limits, an employer must contribute to a SIMPLE 401(k) to the tune of a minimum 3% dollar-for-dollar match or a 2% non-elective contribution. SIMPLE 401(k) are funded with pre-tax dollars and the funds also cannot be touched without penalty until age 59.5.

Safe Harbor 401(k) Plan

The safe harbor version of the 401(k) has more meaning for employers than employees, but it’s still worthwhile to understand how it works. Like the SIMPLE 401(k), the safe harbor 401(k) allows the employer to bypass costly compliance checks. But a safe harbor 401(k) has the higher-level contribution limits: $19,500 and $26,000 for those 50 and over.

Safe harbor 401(k)s also require an employer to match a portion of worker contributions. All workers are eligible to receive this match too. Employers must match 100% of a worker’s 3% salary contribution and 50% of any additional contributions between 3% and 5%. Plus, an employer can also choose a 100% match on 4% of contributions or a nonelective contribution of at least 3% of the worker’s salary.

Work With an Experienced Financial Advisor

If you have any questions about the types of 401(k) plans, reach out to a team member from Good Life Financial Advisors of Mount Pleasant today! We’re happy to assist you.

Disclosure

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.