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Basics of a 401(k) Plan

Today’s 401(k)s hold more than $5.9 trillion in assets with over 100 million people contributing. But what is a 401(k) and would your company benefit from one?

Articles by Betterment Editors
By the Editorial Staff Betterment Resource Center Published Feb. 24, 2020
Published Feb. 24, 2020
6 min read

Since the 1980s, the 401(k) has rapidly become the retirement plan of choice for companies across the United States. In fact, today’s 401(k)s hold more than $5.9 trillion in assets and more than 100 million people have contributed. But what exactly is a 401(k)—and would your company benefit from offering one? Let’s start with the basics.

How Does a 401(k) Work?

Contributions

A 401(k) plan is an employer-sponsored retirement savings plan that enables employees to contribute a portion of their paycheck to a tax-advantaged retirement account. In 2020, employees can contribute up to $19,500 to their 401(k), and if they’re age 50 or older, they can make additional catch-up contributions of up to $6,500.

Under IRS guidelines, employees may make two types of 401(k) contributions: Traditional and Roth. All plans offer Traditional 401(k) contributions, and many also offer Roth 401(k) contributions. Here’s how they compare:

  • Traditional 401(k) contributions are made with pre-tax dollars. This means that contributions are deducted directly from employee paychecks before income taxes are withheld. The money contributed to the plan—and any associated earnings—grow tax-deferred until employees withdraw it, typically in retirement. At that time, withdrawals are considered ordinary income and employees will pay federal and possibly state taxes depending upon where they live. If they want to withdraw money before they turn age 59 ½, they’ll also be subject to a 10% penalty unless they qualify for an exception.
  • Roth 401(k) contributions are made with post-tax dollars. This means that the money is deducted from employee paychecks after tax dollars have been withheld. Because they already paid their taxes, employees can withdraw contributions—and any earnings—tax-free if they’re age 59 ½ or older and have held their Roth 401(k) account for at least five years. (Unlike a Roth IRA, there are no income limits for participating in a Roth 401(k).

Investments

Employees can invest their contributions in a range of options. For guidance on investment choices, talk to your 401(k) provider or financial advisor. When thinking about your investment offering, ask these questions:

  • Does our investment offering provide employees with enough choice?
  • Are our investments cost-effective? For example, does the line-up include indexed mutual or exchange-traded funds?
  • Do we default employees into or at the very least offer diversified portfolios for those who don’t want to choose their own funds?

Enrollment

As an employer, you decide on the eligibility and enrollment methodology. Typically, it is handled in the following ways:

  • Anytime enrollment – Some employers allow both new and existing employees to enroll in the 401(k) retirement plan at any time, including as soon as they’re hired.
  • Conditional enrollment – Some employers require employees to work a certain number of hours or days before becoming eligible to participate. For example, they may require employees be 21 years old and have one year of service before enrolling in the plan.
  • Open enrollment – Some companies only allow employees to enroll in the 401(k) plan during certain defined time frames, such as during a month-long open enrollment period at the end of the year.
  • Automatic enrollment – To encourage employees to save, many employers also include an auto-enrollment feature. With this feature, employees are automatically enrolled in the plan at a certain contribution percentage. For example, employees may be enrolled at a 3% contribution rate. Of course, employees can always opt out before or after they’re automatically enrolled in the 401(k) plan.

Which IRS Requirements Should You Know About?

Because 401(k) plans offer valuable tax advantages, the IRS has a very strict set of requirements that you must follow. For example, employee contributions made under the plan must meet specific nondiscrimination requirements. To ensure that your plan satisfies these requirements, you must perform annual tests verifying that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

In addition, the IRS has specific regulations on participation, automatic enrollment, contribution limits, vesting, distributions, and many other aspects of 401(k)s. Wondering how to navigate the rules and regulations? A qualified 401(k) plan provider like Betterment can help you take care of all the details.

Five questions to ask 401(k) providers

It’s important to choose a provider that not only offers a comprehensive 401(k) solution, but also acts in the best interests of you and your employees. That’s because partnering with the wrong 401(k) provider can leave you vulnerable to high fees, poor investment options, unanticipated administrative burdens, low plan utilization, and misunderstood legal liability. Here are five important questions to ask a prospective retirement plan provider:

  1. How is fiduciary liability allocated between you and the plan?
  2. Do you provide dedicated support and what kind of 401(k) experience does your staff have?
  3. What are the total fees and are they explicitly expressed, rather than embedded in expense ratios?
  4. How do you help me stay on top of my compliance requirements?
  5. How do you help employees make the most of the plan?

At Betterment, we welcome these important questions and invite you to compare our responses with those of our competitors. Find out how we can offer you a better 401(k) plan today.

How Much Does a 401(k) Cost?

When you think about offering a 401(k) plan, a primary consideration is cost—both for your company and your employees. That’s because fees can eat away at returns over time, taking a serious bite out of employees’ retirement accounts. Although it’s common for certain costs to be paid by participants, it’s a good idea to understand how the total costs will impact them.

The main types of expenses associated with a 401(k) plan include:

  • Fund fees
  • Investment management fees
  • Administration and compliance fees
  • Transaction fees
  • Recordkeeping fees

Fees are typically assessed in the following ways:

  • Asset-based: Expenses are based on the amount of assets in the plan, represented as percentages or basis points.
  • Per-person/per-participant: Expenses are based upon the number of eligible employees or actual participants in the plan.
  • Transaction-based: Expenses are based on the execution of a particular plan service or transaction.

Often, expenses are made up of a combination of asset-based and per-participant fees. With asset-based fees, employees with higher balances pay more. With per-participant fees, all employees pay the same amount—therefore, employees with lower balances pay a higher percentage of their account assets (and those with higher balances pay a lower percentage). So as you think about a fee structure, carefully review fees on both a dollar basis and an asset percentage basis, and consider how growth in employees or assets may impact those numbers.

Historically, however, 401(k)s  have had complex fee structures. While fund fees are understandably netted from fund returns, plan providers may also route payments for other services through investment returns. This embedding of fees, while legal and reported, can be difficult for employers and employees to understand and track.

According to the Investment Company Institute, the average fee for plans with $1 million to $10 million in assets is 1.17 percent. At Betterment, our fees are often well below industry average. Plus, we’re always explicit about our pricing. A clearly defined fee structure means no surprises for you—and more money working harder for your employees.

How Does a 401(k) Benefit Employees (and Employers)?

A 401(k) plan offers many valuable benefits for employees and employers alike. For employees, top benefits include:

  1. Convenience—Automatic payroll deductions make it easy for employees to invest for retirement—and potentially grow their money over time.
  2. Matching contributions—Many companies elect to include an employer match to help encourage employees to save (for example, 50 cents on the dollar, up to 6%). Earning “free money” is a top perk for employees.
  3. Tax advantages—Whether employees decide to save on a pre-tax basis, post-tax basis, or both, they enjoy valuable tax benefits, which can benefit their bottom line.

For employers, top benefits of offering a 401(k) plan include:

  1. Talent recruitment and retention—Many employees expect a 401(k) plan to be part of their benefit package—and perks like matching contributions are powerful incentives to join (or stay with) a company.
  2. Tax advantages—You may be eligible for an annual $500 tax credit, and any employer contributions you make to your employees’ 401(k) accounts are tax-deductible.
  3. A stronger, more productive workforce—According to a study from Prudential, every year an employee delays retirement can cost their employer more than $50,000 due to a combination of factors including higher relative salaries and higher health care costs. A solid 401(k) plan can help ease employees’ financial stress—and help them with saving for retirement.

As you can see, a 401(k) plan offers significant benefits, but is it right for your company? Betterment can help you understand the fine points of 401(k) plans and make an educated decision.

Looking for a better 401(k) plan?

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