Summary: A 401(k) account is a US government-regulated savings account enabling both employee and employer contributions, and receiving special tax treatment.
Every employee wants to put away savings for their retirement. Every employer wants to attract top talent to their organization. Is there a way to combine and align these two seemingly unrelated interests? One way is for employers to provide employees with retirement savings plans to which they’ll both contribute, such as 401(k) plans.
Great 401(k) plans can help attract and retain quality employees by providing a way for them to save and grow their retirement income. If you’re an employee looking to learn more about these plans or an employer looking for help setting one up, this article will explain what 401(k) plans are and how they work.
What Is a 401(k) Plan?
In explaining 401(k) plans, let’s start with the name. The term 401(k) doesn’t explain a lot which is a big part of the reason these plans need an explanation. This name simply comes from the part of the U.S. Code where rules for this type of plan are specified.
They’re found in Section 401 (k) of Title 26 of the U.S. Code which refers to “cash or deferred arrangements” of “qualified pension, profit-sharing, and stock bonus plans”.
However, this legal document contains some extremely convoluted and difficult language, which doesn’t help to clarify much. Instead, we’ll break 401(k) plans down for you like this:
A 401(k) plan is a tax-advantaged, employer-sponsored, defined contribution retirement savings plan.
Let’s break down each of these terms to further our understanding:
- Tax-advantaged: 401(k) plans allow participants to defer or put off paying taxes on their income or contributions until a later date, which may be beneficial if they’re taxed at a different rate.
- Employer-sponsored: This simply means that employers set up and offer 401(k) plans for their employees. Other employer-sponsored benefits include health coverage and other insurance plans.
- Defined contribution: Defined contribution plans are those to which both employers and employees regularly make contributions. While these contributions may be equal, this is not a requirement of all 401(k) plans.
- Retirement savings: The purpose of a 401(k) is to provide an employee with an account for their retirement. In general, people can’t make withdrawals from their 401(k) plans before the age of 59 ½ without incurring penalties that effectively negate the benefits of these plans.
However, it’s important to understand that a 401(k) plan is not a savings account like a simple bank account. Instead, these plans work as investment options, and the amounts employees contribute to them can decrease if their investments go poorly.
How Does a 401(k) Plan Work?
An employee who starts a new job may be offered a 401(k) plan or even a choice of plans by their new employer. The employer will choose to offer a defined contribution plan that sees both the employee and the employer contribute to the plan.
The employee chooses how much to contribute to the plan as a percentage of their salary, and the employer will typically match this or contribute a percentage of this amount. Their maximum contributions are limited by the annual contribution limit set by the IRS.
The employee signing up for the 401(k) plan then selects the investment vehicles they want to use from a range provided by the employer’s plan. These investments can include:
- Mutual funds
- Stocks (including stock in the employer’s company)
- Bonds
- Guaranteed investment certificates (GICs)
- Lifecycle funds (also known as target date funds or TDFs)
The investments selected should take the employee’s risk tolerance level into consideration and provide a mix of different types to make the portfolio more robust.
Once the employee is registered for the 401(k) plan, their contribution information will be added to their payroll calculation. In each subsequent pay period, the agreed percentage of their salary will be deducted by the employer and paid to the plan.
The employer also makes their own contributions. 401(k) plans may be administered by the employer as the plan sponsor or by a third-party administrator.
When the employee retires, the 401(k) account containing the contributions and their employer’s contributions becomes accessible to the employee. This account will also include earnings, if any, made from their investments. The payments taken from 401(k) accounts are called distributions.
How Are 401(k)s Taxed?
Anyone can put money in a bank account and save it for a rainy day. The difference with a 401(k) account is that it provides tax advantages when compared with a regular savings account.
These tax advantages depend on which of the two major types, traditional or Roth, of 401(k) plan the employee contributes to. These two major types of plans are taxed very differently:
Traditional 401(k) Plan
With a traditional 401 (k) plan, the employee’s contributions are not taxed. They are taken directly from their earnings before they are subject to (income, Social Security, and Medicare) taxes. This has the effect of reducing their tax liability for each pay period since their gross income is reduced before taxation is applied.
However, when the employee reaches retirement age and starts to take distributions from their 401(k), these amounts are taxed as income. So, what’s the tax advantage?
Most people make more money while they’re working than in their retirement years, and their income level will therefore fall within a low tax bracket once retired. This will mean that their 401(k) contributions can be taxed at a lower rate, giving them a tax advantage.
Roth 401(k) Plan
Roth 401(k) plans offer a sort of reversal to the tax deferral of traditional plans. Contributions to Roth plans are made from income after taxes have been applied, which means that they don’t offer any tax savings at that time.
However, because these amounts have already been taxed, they’re not counted as taxable income when the employee retires and starts collecting distributions.
Employees who expect to be in higher tax brackets when they retire than they are while working can benefit from Roth plans. While this is less common, it’s possible if a 401(k) plan is started very early and expected to grow for decades, producing more income than the employee could earn while employed.
People with lots of investments that will pay off in the future may also choose Roth plans, which will reduce their tax burden later in life.
Taxes for Employer Contributions
Employers can generally gain a lot of advantages from offering 401(k) plans to their employees. Not only can these plans help them attract and retain quality employees, but they also offer tax advantages. Employer contributions up to a set limit can be deducted from their federal income tax returns.
Payroll taxes, like SUTA (state unemployment insurance taxes) and FUTA (Federal Unemployment Tax Act), are usually not applied to these employer contributions. This means employers can offer better overall compensation with lower tax burdens.
How Much Can Be Contributed to 401(k) Plans?
The IRS places strict limits on the amounts that both employees and employers can contribute to 401(k)s. These limits are adjusted each year to account for inflation.
In 2025, the annual contribution limit for employees under the age of 50 will be increased to $23,500. However, employees over the age of 50 who did not reach their maximum contributions in previous years can make catch-up contributions of up to $7,500 in 2025. This means that employees over 50 can contribute up to $31,000 to their 401(k)s this year.
Be aware that employers’ contributions don’t count toward this total.
Instead, employers have their own limits. In 2025, total contributions for employees under 50 can’t exceed $70,000 which means that employers can contribute as much as ($70,000 – $23,500 =) $46,500 to their employees’ 401(k) plans. For employees over 50, the combined limit is $77,500, so the maximum employer contribution is still the same ($77,500 – $31,000 = $46,500).
How to Start a $401(k) Plan for Employees
It can be a lot easier than you think to start a 401(k) plan either on your own or with the help of a third-party administrator (TPA). If you work with a TPA, they’ll likely have plans ready to offer you but if not, you’ll need to draw up your own. You’ll then need to arrange a trust fund to hold your employees’ money and choose trustees to take responsibility for the fund.
You’ll also need to choose a system to keep track of contributions, earnings, losses, and distributions. When your plan is ready, you can present it fully to your employees, letting them choose their rates and investments.
401(k) Plans Summarized
If you want to provide retirement savings plans for your employees, 401(k)s are a popular choice. These plans are sponsored by employers who make contributions to them regularly, along with employees. They’re tax-advantaged but also represent investment funds that should be managed carefully to protect and, hopefully, grow your employees’ retirement income.
FAQs
No, they’re tax-advantaged. This means that your employees pay taxes either on the initial amounts they contribute (Roth 401(k)s) or on the withdrawals they make later (traditional 401(k)s). The advantage is that the employees’ funds can be taxed less if they choose to be taxed when they’re in a lower income tax bracket.
Yes, but if you take money out before the age of 59 ½, you’ll normally pay a 10% penalty. However, employees can make withdrawals of up to $1000 without penalties for personal or family emergencies so long as they repay the funds within three years.