401(k) Plan Design
401(k) plans are a type of profit-sharing qualified retirement plan that are widely used by employers of all sizes to help recruit and retain quality employees.
These plans are required to meet certain criteria under ERISA guidelines, which means that all of them have to have the same specific characteristics built into them by design.
However, there are many ways in which 401(k) plans can also be unique, as many of the plan provisions can be customized from one plan sponsor to another.
So it is important for employers to understand how 401(k) plans are designed so that they can maximize the benefits that these plans provide for both themselves and their employees.
Here is a breakdown of how these plans are designed and the ways that they can be customized.
401(k) Plan Design Process
The actual process of matching a 401(k) plan’s basic features with the plan sponsor’s goals is known as plan design.
Different types of employers can have very different goals that they want to achieve with their 401(k) plans.
One employer may want to maximize contributions for the business owners and highly-compensated employees, while another seeks to incentivize employees to save for their retirements and stay with the company for the long term.
401(k) Plan Design Example
When it comes to plan design, there are six elemental components of a plan that can be adjusted to meet a given employer’s needs and goals.
They are:
- Eligibility – Employers have some latitude regarding who they allow to participate in their 401(k) plan. They can often exclude part-time employees or independent contractors, or those who have less than a year of service to the employer or are under 21 years old. If the employer is seeking to increase and retain its workforce, then it will take a more inclusive approach in plan design while employers that are primarily establishing the plan for their own use will include the smallest possible number of participants. Employers can also limit enrollment in their plan to certain times, such as an annual, semiannual, quarterly or monthly window of time during which the plan will accept new participants.
- Compensation – Employers also have some latitude regarding which types of compensation they include when calculating items such as matching contributions. Any money that was earned by an employee before becoming eligible to participate in the plan can be excluded, as can certain types of fringe benefits and anything paid to highly compensated employees. But most employers stick to straight W-2 compensation because it is the easiest to calculate and obtain.
- Contributions – The IRS limits the amount of money that can be contributed to a 401(k) plan by an employee to the lesser of 100% of the employee’s compensation or a certain dollar amount each year that is adjusted annually for inflation. Employers may pose additional limits on elective deferrals if they so choose. The area where employers have the most leeway is with matching contributions, which many employers will subject to a vesting schedule. Matching contributions can be made for a certain percentage of an employee’s compensation, or can be a set percentage of an employee’s contributions. For example, an employer can match the first 3% of the employee’s elective deferrals, or it can match 50% of any amount of an employee’s elective deferrals.
- Vesting – Many employers use a vesting schedule as a tool to retain employees. The employer can use either a cliff or graded vesting schedule. A cliff vesting schedule is where the employee becomes fully vested in the employer’s matching contributions after a certain period of time, such as five years. Or it can use a graded vesting schedule, where the employee becomes progressively more vested in the matching contributions each year until the employee is finally fully vested.
- Distributions – Most employers allow distributions from their 401(k) plans under certain circumstances. Retired employees are of course able to take distributions from their plans if they are at least 59 ½ years old. And employees who leave the company are able to roll over their plan into either their new employer’s qualified plan or an IRA without penalty. Some plans also allow employees to take one or more in-service distributions from their plans, while other plans may only allow qualified hardship distributions.
- Loans – Loans are an optional feature that employers can add to their plans if they so choose. Loans are typically limited to 50% of the current plan balance, or perhaps half of the employee’s elective deferrals. Loans can be popular with plan participants who have no other way to access funds when they need them, but they come with additional costs and administrative complexity for the employer.
These six features are all customizable for each employer, and as a group they constitute plan design.
Plans can be designed in dozens of different ways depending upon the wants and needs of both the employer and the workforce.
401(k) Plan Design FAQs
401(k) Plan | A Complete Beginner's Guide
401(k) Meaning
The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.
Traditional 401(k) vs Roth 401(k)
There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.
Contributing to Your 401(k) Retirement Plan
Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.
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Plan in Advance
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.