What is a 401(k) plan?
A 401(k) retirement plan is a savings option that allows owners and employees to deposit a part of their pre-tax salary into their retirement savings. By setting aside a small contribution from each paycheck, one can allow their savings to grow into a considerable amount that they can use when they stop working or retire. Since the contributions to the retirement plan are pre-tax, in the short term you will have a small tax burden while your investments grow in the long term in a tax-free environment.
Understanding the Benefits of a 401(K) Plan
All 401(k) retirement plans allow both employers and employees to enjoy substantial benefits as listed below:
- Ability to save more as compared to IRA or Individual Retirement Account.
- Option to contribute as high as 25% of the employee’s income to retirement savings.
- Higher contribution limits for both employees and employers when compared to a traditional IRA. For example, when you contribute say $19,000 in 2019 through a 401(k) plan your limit is raised to $19,500 in 2020. However, the maximum contribution limit remains the same at $6000 in both 2019 and 2020 with a traditional IRA.
Different Types of 401(k) Plans
Small Business 401(k): A small business 401(k) plan is similar to any 401(k) plan for a large business and allows you to contribute a pre-decided amount from your pre-tax salary to your retirement savings. The 401(k) plan provides the same limit for maximum contribution regardless of the size of the business. This plan is suitable for individuals or small businesses since it is free of any asset management charges and does not require a lot of time to handle the plan.
Individual 401(k): This plan is specially designed for businesses with sole-proprietors or self-employed individuals. It is commonly known as the solo or self-employed 401(k). It is simple to manage for an individual and offers similar savings flexibility and tax benefits as any other 401(k) plan.
Self-Directed 401(k): Similar to any traditional 401(k) plan, this plan allows you to automate salary deductions and have pre-tax savings. The advantage of a self-directed 401(k) plan is that it allows you to choose where to invest the funds.
SIMPLE 401(k): A SIMPLE plan is a mix of the traditional 401(k) plan and IRA. Similar to the provisions of a traditional 401(k) plan and IRA, it allows both owners and the employees to take a loan against their retirement funds. This plan is compliant with the annual IRS non-discrimination tests so employers do not need to worry about the testing each year. The only disadvantage with this plan is the limited ability to customize it and lower contribution limits.
If you are looking to start a 401(k) plan for your business, contact a plan provider who will help you understand which plan suits your business goals, and assist you in setting up the plan.