What Are the Different Types of 401(k) Plans and Their Advantages?

401(k) Plan Definition

A 401(k) plan is a retirement savings plan sponsored by an employer. Employees can contribute a percentage of their pretax income to the account, up to a limit set by the Internal Revenue Service (IRS). The contributions are not taxed until they are withdrawn from the plan. Employers often match a portion of employee contributions.

Types of 401(k) Plans

There are several different types of 401(k) plans:

Traditional 401(k)

A traditional 401(k) is the most common type of 401(k) plan. Contributions are made with pre-tax dollars, and earnings grow tax-deferred. When you withdraw money from the account, you will pay taxes on the withdrawals.

This type of plan offers a wide range of investment options to employees. Employers in this type of plan make matching contributions.

Traditional_401(k)_Plan

Roth 401(k)

A Roth 401(k) is a newer type of 401(k) which is closely the same as a traditional 401(k) except for a few things. Contributions are made with after-tax dollars, but earnings grow tax-free. When you withdraw money from the account, you will not pay taxes on the withdrawals.

Roth_401(k)_Plan

Safe Harbor 401(k)

A Safe Harbor 401(k) plan is similar to a traditional 401(k), but it offers more protection for the employer. Employers are no longer required to pass the nondiscrimination tests each year to offer them.

This type of plan may be offered by public or private employers regardless of size. Employers are mandated to make a contribution to the plan either on a matching or nonelective basis with certain limits set by the IRS annually.

Safe_Harbor_401(k)_Plan

SIMPLE 401(k)

A SIMPLE 401(k) stands for Savings Incentive Match Plan for Employees. It is similar to a traditional 401(k), but it sets a much lower limit on contributions and allows employees to save more money.

Employers must offer matching contributions of up to 3 percent of an employee’s salary or make non-elective contributions equal to 2 percent of each eligible employee’s salary.

Businesses with less than 100 employees can offer this type of 401(k) plan. Employee contributions are made using pre-tax dollars and any qualified withdrawals made shall be taxed at the ordinary income tax rate of the employee.

SIMPLE_401(k)_Plan

Solo 401(k)/Self Employed 401(k)

A Solo 401(k) plan is a variant of a traditional 401(k) used by self-employed individuals and small business owners without any employees other than themselves.

Contributions made into the plan are tax-deductible and any qualified withdrawal shall be taxed using the employee’s ordinary income tax rate.

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Final Thoughts

401(k) plans are a great way to save for retirement. Employees can contribute a percentage of their pretax income, and employers often match a portion of employee contributions.

There are several different types of 401(k) plans available, each with its own set of benefits and restrictions. It is important to understand the differences between these plans so you can choose the one that is best for you.

Yes. This can be done through a rollover, which is the process of transferring money from one retirement account to another.
It depends on your goals and financial situation and the availability of the plans as offered by your employer.
You have two options: roll over or cash out.
No. Depending on the plan, employees may have the option of making Roth 401k contributions from after-tax dollars.
Nondiscrimination tests are used by employers to make sure everyone is benefiting equally from the company's 401k plan. Employers must pass these tests every year to avoid penalties with employee elective deferrals and employer contributions.

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.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

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.

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