Definition of 401k

Definition of 401k

December 14, 2023
Definition of 401k

A 401k plan is a retirement savings plan offered by an employer to eligible employees. The plan may take payroll deductions pre-tax, as a traditional 401k plan structure, or after-tax as a Roth 401k plan structure.

What is a 401k retirement plan?

A 401(k) is a qualified benefit plan that allows eligible employees a vehicle to set money aside for retirement purposes.

Qualified benefit plans are plans that are subject to the IRS’ mandates and rules and must also comply with the principles set forth by the Employee Retirement Income Security Act of 1974 (ERISA). These plans are strict and must comply with several guidelines, including standards regarding:

  • Benefit accrual
  • Contribution limits
  • Funding restrictions
  • Investment restrictions
  • Participation requirements
  • Vesting definitions

401(k) plans offer a means for employees to have monies automatically deducted from their paycheck and invested in a secure retirement account on their behalf. These plans have legal, documented guidelines and parameters detailed in a Summary Plan Description (SPD). This document must be available to all employees eligible to participate in the program.

Because these plans are strictly regulated, they are also subject to specific annual discrimination testing and reporting.

Why is a 401k plan important to your business?

According to an article in Forbes, the only benefit employees value more than a company-sponsored retirement plan is flexible work hours. Companies that offer a 401(k) retirement savings plan along with a company contribution match are more attractive to potential hires than those without. Additionally, those that provide a substantial contribution match are more likely to retain their employees.

While the IRS caps the annual allowable employee contribution, they don’t dictate the maximum match a company can offer. Even so, a 2021 study conducted by Vanguard found the average company match generally tends to be about 4.5%. Although the “first 4.5% rule” is expected to remain average, some employers can choose to be more generous.

Provided the company’s SPD details the option, employees can also contribute a specific percentage of their after-tax income to their 401(k) savings plan.

401k plans aren’t only for large corporations

Small businesses with 100 employees or fewer and whose staff each earned at least $5,000 the previous calendar year are eligible to consider offering a “Simple 401(k) plan” to help employees with their retirement savings rather than being limited to a traditional plan. These plans are still governed by the IRS. One requirement for these plans includes 100% vesting in any employer contributions.

The rules and guidelines for the Simple 401(k)/IRA plan are slightly different from the traditional 401(k). Still, they offer a reasonable means for employees to save for retirement.

Employers are also able to contribute a match of up to 3% of the employee’s pre-tax income in the Simple Plan, which must be immediately vested in the program.

What is the history of 401k plans?

401(k) plans first appeared on the banking scene in 1978. Since that time, they have become the preferred vehicle employers use to help employees save for their future retirement.

Companies that offer qualified 401(k) plans provide benefits both for the employer and the employee.

  • Employers who sponsor qualified 401(k) plans qualify for certain tax benefits, including governmental tax breaks and tax credits
  • Employee funds contributed to qualified 401(k) plans must be kept separate from all other business funds to ensure the monies are protected
  • Employees who participate in and make contributions to 401(k) plans have an opportunity for a portion of their earnings to be tax-deferred until they withdraw their funds from the plan without rolling them over to another qualified retirement savings plan.

Because of the tax deferral benefit, the IRS has placed limits on the maximum salary amount eligible for contribution participation. Although that amount changes annually, the salary cap for 2023 is $330,000.

The government caps the 2023 annual employee pre-tax contribution amount at $22,500. However, if the employee is over 50, they can work to “catch up” on their contributions. These employees can contribute another $7,500 for a maximum annual contribution amount of $30,000.

Other terms similar to 401k and related articles that can help you

  • IRA (Individual Retirement Account): An investment account that lets individuals save for retirement. An IRA can be traditional, meaning pre-tax, or Roth, meaning after-tax.
  • 403(b): A retirement plan for a specific class of employees employed by schools, non-profit (501(c)(3) tax-exempt) organizations, and qualifying ministerial positions.
  • KEOGH: A tax-deferred retirement plan for self-employed individuals or unincorporated businesses.

401k summary

A 401(k) plan is one of the most desirable benefits an employer can offer existing and prospective employees. It is an employer-sponsored retirement savings account to which employees can contribute pre-tax earnings. Employers also have the opportunity to provide an employer match to receive certain tax benefits.

Similar glossary terms you must know

  • Actual contribution percentage (ACP) test: A type of annual 401(k) nondiscrimination test to ensure the plan does not disproportionately favor highly compensated employees over non-highly compensated employees. The ACP test considers employer 401(k) match contributions and/or employee after-tax contributions.
  • After-tax contributions: Usually refers to 401(k) contributions that are deducted from the employee’s wages after income taxes are taken out. After-tax contributions do not reduce the employee’s taxable wages.
  • Professional employer organization (PEO): An outsourced organization hired to complete processes (often HR) instead of companies ultimately building those processes in-house.
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