Retirement plans are one of the top benefits that employees look for when considering a company: our Workforce Financial Wellbeing Report found that employees expect retirement savings as an essential benefit, second only to paid sick leave.
Out of the different types of retirement plans out there—Roth and SEP IRAs, pensions, 403(b) plans—401(k) are among the most common.
The administrative burden and costs of 401(k)s can make it harder for smaller companies and startups to get set up at first, though there are tax credits and incentives that can help offset that burden. But given that retirement savings is the #1 financial benefit that would influence an employee’s decision to join a company (again, this data is from our Workforce Financial Wellbeing Report), it’s one of the strongest tools available both to attract and to retain high-quality employees.
If you’re looking into setting up your company’s 401(k) structure for the first time, the IRS has lots of resources that can help, but going through everything can be a little overwhelming. To help you get started, we’ve put together this easy-start, comprehensive guide to 401(k)s for employers.
PS - Remember, Sunny Day Fund doesn't offer retirement plans or retirement planning. We offer emergency savings as a benefit, which is a great way to help employees save for unexpected expenses and avoid tapping their retirement savings.
Let’s start with the basics: What is a 401(k)?
A 401(k) is a defined contribution plan that allows employers to contribute to the savings employees put aside for retirement.
Defined contribution plans are different from pensions, where retired employees are guaranteed a set amount per month for the remainder of their lives. With 401(k)s (and IRAs, and most American retirement plans), there’s no guaranteed income - instead, the employee is responsible for managing their retirement funds and ensuring they have enough to retire comfortably. It also makes things much simpler for employers, since they know how much they’ll be contributing and how much paying towards their employees’ retirement will cost. Today, 401(k) and other defined contribution plans are much more common in the United States than pension plans.
Employers are not yet legally required to provide a 401(k) or other retirement plan at a federal level, but that may change soon with Secure Act 2.0. Many states have laws that do require businesses to help employees plan for retirement, including California, Connecticut, Illinois, Massachusetts, Oregon, and Washington. Several more states including Virginia have passed or introduced legislation requiring retirement plans.
Fun fact: 401(k)s are named after the section in the Internal Revenue Code (IRC) that covers the topic.
The benefits of offering a 401(k) plan
Offering retirement benefits helps your company be competitive in a tight job market. With two offers offering similar income, employees will likely consider benefits like 401(k)s and 401(k) matching to decide which company to work for.
Offering retirement plans also contributes to employee well-being, especially in the long-term, enabling employees to retire securely and stop working when they can no longer do so.
There are also government tax incentives for companies who set up retirement plans for their workforce, especially small businesses getting ready to start offering 401(k)s for the first time.
Eligible employers can receive a tax credit of up to $5,500 to cover startups for the first three years of the plan and using an auto-enrollment feature.
Employers also aren’t required to match a portion of employees’ 401(k) contributions, but those who do can benefit from some significant tax incentives that we discuss below. For example, the money that a business contributes to their employees’ 401(k) plans is tax-deductible, up to 25% of the total compensation of eligible employees each year.
401(k)s for employers: Getting started
The first step to offering retirement plans is figuring out which kind you want to offer. There are several different types, including safe harbor, traditional, and SIMPLE 401(k)s, as well as SEP IRAs.
Once you’ve chosen the type of 401(k) you want to offer, the IRS outlines four basic steps to getting set up:
- Adopt a written plan
- Arrange a trust for the plan’s assets
- Develop a record-keeping system
- Provide written plan information to employees
401(k) matching
Many employers choose to “match” what employees contribute to their retirement fund, up to a certain amount.
Matching employee contributions isn’t required, but it is somewhat expected: CNBC reported that “98% of 401(k) plans pay a company match or profit-sharing contribution.”
Companies can use different contribution matching formulas. A few options include:
- Dollar for dollar matching, up to a set amount
- Example: an employee contributes $4,000 annually, their employer matches that with the same $4,000 amount, up to a certain limit
- A percentage of each dollar, up to a set amount
- Example: an employee contributes $4,000 annually, their employer matches that with 50% of that amount ($2,000), up to a certain limit
- Dollar for dollar matching, up to a percentage of that employee’s salary
- Example: An employee who makes $40,000/year contributes $4,000 annually, their employer matches that up to 5% of their salary ($2,000)
- A percentage of each dollar, up to a percentage of that employee’s salary
- Example: an employee who makes $40,000/year contributes $4,000 annually, their employer matches that with up to 5% of their salary ($2,000)
When developing your matching strategy, don't forget to also apply your DEI lens. Often, a percentage and salary-driven approach could exacerbate an underlying income issue.
401(k) vesting schedules
The amounts that employees contribute to their retirement funds are immediately 100% vested—that means that they belong to the employee (after all, they’re the ones who put it there!).
Depending on the type of plan, employer contributions follow different vesting schedules. This can incentivize employees to stay with the company longer (though it can also put you at a disadvantage if it makes your benefits look less appealing than the competition).
- With immediate vesting, employees own 100% of employer contributions right away.
- With graded vesting, employees own a growing percentage of employee contributions over time (50% the first year, 75% the second, and 100% starting the third year, for example)
- With cliff vesting, employees own 100% of their employer’s contributions after a set period of time. In this scenario, employers are legally obligated to fully vest their employees by the end of the third year of employment at the latest.
No matter what vesting schedule you ultimately choose, it needs to be clearly spelled out in your401(k) plan document.
Rules for offering 401(k)s
401(k)s follow a series of plan qualification requirements and legal rules set out by the IRS in order to qualify for the tax advantages they offer, both for employers and employees. These rules cover topics like contribution limits, non-discrimination requirements, eligibility, distributions, as well as 401(k) loans and hardship withdrawals.
Eligibility
Employees who meet the eligibility criteria set out by the IRS must be allowed to participate in your company’s retirement plan. You can allow employees to participate sooner if you choose.
Requirements:
- Employee is 21 or older
- Has at least 1 year of service at your company
Contribution limits
Contribution limits determine how much employees and their employers can contribute to their 401(k), and are subject to periodic revisions. Contribution limits are set at $20,500 in 2022, which is up from $19,500 in both 2020 and 2021.
In addition, individuals aged 50 and over can make additional catch-up contributions.
Total employer and employee contributions have their own caps, and cannot exceed 100% of the employee’s salary.
Distribution rules
Distribution happens when 401(k) participants begin withdrawing money from their account and using that money as retirement income. Per the IRS’s rules, distribution can only happen when a “distributable event occurs.”
These include:
- The employee reaches 59 ½ years of age
- The employee dies or becomes disabled and unable to work
- The plan ends and no other defined contribution plan is set up to replace it
- The employee suffers a financial hardship (more on this below)
On top of this, 401(k)s are also subject to required minimum distributions when recipients reach 72, or they will face tax penalties.
Compliance and non-discrimination testing
401(k)s need to give rank-and-file employees the same opportunities to save for the future as key employees who make above a certain amount. If key employee accounts hold more than 60% of the value of your plan assets, then your 401(k) is “top-heavy” and you’ll need to correct it.
The IRS uses two main annual discrimination tests that funds must pass:
- The Actual Deferral Percentage (ADP) test
- The Actual Contribution Percentage (ACP) test
Both tests compare average contributions made by highly-compensated employees (HCEs) and non-highly compensated employees.
401(k) loans and hardship withdrawals
Most plans allow for hardship withdrawals in cases of “immediate and heavy financial need.” Hardship withdrawals are taxed upon withdrawal, and they do not need to be paid back into the 401(k) fund. Hardship withdrawals have unfortunately increased in the last few years.
401(k) loans are slightly different, as individuals are essentially borrowing from their future selves. The money must be paid back into the fund within five years, with interest. Under IRS guidelines, employees can borrow up to 50% of their vested account balance or $50,000 (whichever amount is lower).
Both 401(k) loans and withdrawals make it harder for employees to save enough for their retirement and can cause them to retire later. Unfortunately, a lack of emergency savings means that 401(k)s loans or hardship withdrawals are often the only options when a financial emergency arises.
What’s changing in the world of 401(k)s
There are exciting new developments happening in the world of 401(k)s that employers should be aware of, especially if they are looking into setting up a plan for the first time.
The House passed the Secure Act 2.0 in March, and the Senate is considering the Retirement Improvement and Savings Enhancement to Supplement Health Investments for the Nest Egg (RISE and SHINE) Act, which covers similar topics.
These bills have overwhelming bipartisan support—their final versions are still uncertain, but they will almost certainly bring sweeping and necessary changes to how retirement planning and saving work in this country.
Some of the changes the bills consider include:
- Mandatory automatic enrollment for new plans
- Increases in catch-up contributions for older employees
- Mandatory inclusion of long-term part-time employees in company retirement plans
- Student loan matching (employers can match student loan payments with retirement contributions
- Extra tax incentives for smaller companies and employers offering 401(k)s for the first time
- Pension-linked emergency savings, allowing employers to match employee contributions to a separate workplace emergency savings plan
These changes will help tackle the ongoing retirement crisis and help some of the country’s most vulnerable build up stronger emergency savings. It also aims to lower the financial and administrative burden on companies offering retirement plans to make the workforce more resilient.
Set up Sunny Day Fund to attract and retain a more financially-resilient workforce with employer-rewarded emergency savings today. Get in touch.