Understanding the Basics of a 401(k) Plan
A 401(k) plan is like planting seeds for a future harvest. Instead of spending all your money today, you set aside some to grow over time, setting yourself up for a potential financial harvest when you retire. Let's explore what a 401(k) is, its benefits, and how to explain these benefits to employees in simple terms.
What is a 401(k)?
A 401(k) is a retirement savings plan offered by many employers. It allows employees to save a portion of their paycheck either before taxes are taken out (pre-tax deferrals) or after taxes (Roth deferrals). The money is then invested and grows over time until retirement.
Key Features of a 401(k)
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Employee Contributions: Employees decide how much money to put into their 401(k) from each paycheck. This is like choosing how many seeds to plant in a garden. The more seeds planted, the more is expected to be harvested in the future.
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Employer Contributions: Some employers will match employee contributions up to a certain amount. This is like the employer giving extra seeds to plant, which helps the garden yield more fruit in the future. These contributions are added compensation on top of wages, almost like a bonus that is invested for your future.
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Vesting: Employees' contributions and safe harbor contributions are always theirs 100%. However, employer contributions may be forfeited if employees leave the company too early. For example, if the plan has a three-year vesting period and an employee resigns during the second year, they may forfeit a portion of the 401k. Think of it as how much of the shared garden employees get to keep if they leave the company.
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Investing Contributions: The money contributed to a 401k is invested, which can help it grow over time. This growth is like watching seeds sprout into a fruit and vegetable garden over time.
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Asset Protection: A 401(k) is protected from creditors, meaning retirement savings are shielded from most legal claims, providing an extra layer of security.
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Safe Harbor Benefits: A safe harbor 401(k) plan ensures that everyone gets a fair share of seeds. Employers commit to making certain contributions, ensuring that all employees benefit, regardless of their income level. This simplifies the plan's administration and ensures compliance with government rules.
Explaining 401(k) Benefits to Employees
We hear of questions from business owners about how to describe their 401k plan to their employees. Here are a few plainly written topics worth mentioning to employees.
Tax Benefits for Reducing Your Paycheck
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Pre-Tax Contributions: Putting money into a 401(k) before taxes means paying less tax now on your annual tax return. Future withdrawals of 'pre-tax' contributions will be taxed based on your income tax rate. If you have a high tax rate today, you may be a good fit to use the pre-tax contributions.
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Roth Option: Some plans offer a Roth 401(k), where taxes are paid upfront, but withdrawals in retirement are tax-free. If the current tax rate is lower than it will be in the future, it probably makes sense to use the Roth.
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Tax-Deferred Growth: Both pre-tax and Roth investments in a 401(k) grow tax-free over time, which can lead to a bigger harvest in the future.
Employer Matching Contributions
Employer matching contributions are like getting free seeds. Employees that contribute enough, can receive a matching contribution up to certain levels. Review your summary plan document to see how much is necessary to receive the matching contribution.
Safe Harbor Contributions
Safe harbor contributions are guaranteed contributions to employee retirement plans. These contributions occur whether or not an individual participates in the plan.
Investments
401(k) plans are typically invested with the hopes of growth over time. The earlier the saving begins; the more time money has to grow.
For example, if an employee defers 10% of an $80,000 salary ($8,000 annually) and the salary grows at an average rate of 3% per year, the employee could have $1M after 30 years of work (assuming 6% investment growth).:
By the end of 30 years, the retirement account could have over $1 million, illustrating the power of letting savings grow over time.
Real World Example for Employees
Here is an example of how a plan might work, using a sample 401(k) plan:
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Features:
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Safe harbor contribution of 3% of compensation.
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Discretionary employer match.
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Profit sharing contributions.
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Compensation Example:
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Salary: $80,000
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Employee Contribution: $8,000 or 10% of their paycheck
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Safe Harbor Contribution: $2,400 (3% of $80,000)
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Employer Match: $3,200 (100% of the first 3% and 50% of the next 2%)
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Profit Sharing: $4,000 (5% of $80,000)
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Total Employer Contribution: $9,600
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To calculate the Hourly Benefit of the 401(k) from the total employer contributions, divide the total employer contribution by the number of work hours in a year (assuming 2,080 hours for full-time work):
Hourly Benefit: $9,600 / 2,080 ≈ $4.62 per hour
When employees compare compensation at different offices, the 401(k) benefit should be part of the equation.
If an employee's wage is $38 per hour, the 401k benefits add $4 per hour in our example. The total wage is $42 per hour. This is a concept called total compensation.
Employer contributions typically occur in the following calendar year, and the values received by the employee are provided on their annual plan statement so they can see how much they receive. At a minimum, if they are in the plan, they will receive a safe harbor contribution.
By using these analogies and examples, owners can make the concept of a 401(k) more relatable and encourage employees to take full advantage of this valuable benefit. The goal is to help them see their 401(k) as a vital part of their financial future, ensuring a fruitful retirement.
We assist our business owner clients in establishing from 401(k) plans for their business. If you would like to discuss this topic in more detail, please book a call below.
