Broker Check

Employer Education: How Does a 401(k) Plan Work?

A 401(k) plan is a type of retirement plan that is offered by employers for the benefit of their employees, named after Section 401(k) of the Internal Revenue Code. These plans permit employees to contribute to their retirement account through payroll deductions. Deposits in the 401(k) plan are invested in stocks, bonds, and mutual funds, and will hopefully increase in value over time, giving employees money on which to retire.

What are the Benefits of a 401(k) Plan?
 If your employees understand how your plan works, they’ll realize how the plan can benefit them. However, if employees remain confused about how your plan works, it could limit their participation, potentially jeopardizing their financial security.

Here are five ways your 401(k) plan can benefit your employees:

  • Tax advantages: Generally, balances plus interest are taxed when disbursed. Additionally, balances receive tax-deferred compounded interest while inside the account.
  • Employee investment control: Employees can choose how much to deposit into the plan while choosing their investments from those provided.
  • Payroll deductions: Employees can make automatic deposits into the plan from their paycheck, making saving easy.
  • Matching contributions: Employers can “match” up to a certain percentage of the employee’s deposit, meaning the employee gets more money deposited into his or her plan account.
  • Portability: If your employees leave their job at your company, they can take all of their employee contributions with them, by rolling the money over into an IRA, another retirement plan, or cashing out their balance. They also can take some or all of their company contributions, depending upon the plan’s vesting schedule.

Understanding a 401(k) Plan’s Terminology
 To understand the benefits of a 401(k) plan, you’ll need to explain the plan’s features in a language that your employees comprehend. Here’s a list of twelve of the most confusing 401(k) terms defined in plain English for your employees.

1. Enroll.
Before you enroll in a 401(k) plan, you must meet the plan’s eligibility requirements, such as attaining age 21 or being employed by the company for a certain period. Once you meet these requirements, you can enroll in the plan, where you become a plan participant. Once you join, you can start making employee contributions, or deposits, into the plan as well as taking advantage of any employer contributions to your plan account.

2. Contribution.
As a plan participant, you can make employee contributions to the plan through a payroll deduction. The amount you choose will be automatically withheld from your paycheck and will be deposited into your plan account. You can also receive employer contributions, or deposits, to your account, such as a matching contribution.

3. Contribution Limits.
Employees cannot contribute unlimited amounts to their plans. The government provides contribution limits for both employees and employers. The IRS adjusts these amounts for inflation at the end of each calendar year. For example, in 2019, an employee under the age of 50 can contribute up to $19,000 into her or his 401(k) plan. If that employee is 50 or over, he or she can contribute a maximum of $25,000.

4. Deferral.
A deferral is an amount that an employee can contribute to the plan. These amounts are withheld automatically from the employee’s paycheck and deposited into the employee’s plan account.

5. Match.
A matching contribution, or a match, is the amount of money that the employer deposits into the employee’s plan account. These contributions are calculated using a percentage. For example, if an employer matches 100%, then that employer will contribute a $1.00 for every dollar that employee deposits into the plan. This match is free money, thus increasing how much employees can put away each year.

6. Allocation.
An allocation, or asset allocation, describes the investment mix in the plan. For example, employee and employer deposits can be invested in stocks, bonds, or mutual funds. The plan offers a menu of investment options from which the employee can choose.

7. Pre-tax / Roth.
Deferrals, or deposits, can be categorized as either a “pre-tax” contribution or a Roth contribution. For pre-tax, the IRS treats these deposits as tax deductions, meaning you don’t pay tax on the money you contribute to your 401(k) plan.

A Roth contribution is the opposite of a pre-tax contribution. Here, the employee contributes after-tax money or salary from which taxes have been withheld. Upon retirement, the employee can withdraw these Roth contributions tax-free.

8. Target Date Funds (TDF).
Target date funds are a type of investment option based on the employee’s “target retirement date.” For example, an investment option may be named a Target Date Fund 2030, estimating a retirement date around 2030. The investments in the TDF become more conservative as the year 2030 approaches. In other words, TDFs help employees stay on track in achieving their retirement goals.

9. Glide Path.
A glide path is the TDF’s formula for calculating the investment mix, based on the number of years to the proposed retirement date. As employees move close to the TDF’s estimated retirement date, the combination of stock, bonds, and mutual funds is adjusted to become more conservative.

10. Hardship Withdrawal.
If you have a financial emergency, you can withdraw some money from your plan. To do this, your emergency must meet specific IRS rules, such as preventing your home’s foreclosure, purchasing a primary residence, or paying for college for you, your spouse or your children. To receive this withdrawal, an employee must prove that the distribution is necessary to satisfy an immediate and severe financial need.

11. Risk.
Risk means different things to different people. For 401(k) plans, risk refers to whether or not an investment is more likely to lose money. The higher the risk, the more uncertain the investment. Instead of using terms like risk, employers can emphasize “staying on track to achieve retirement goals” to employees.

12. Post-Retirement Options.
Finally, describe post-retirement options to employees and watch their eyes glaze over. However, explain the benefits of staying in the plan after an employee retires. When defined in this manner, a recent study found that 92% of employees would keep their investments in their company’s plan after retirement.

401(k) Participant Education: Wrapping Up
 By using easy-to-understand descriptions, employers can reduce their employees’ misunderstandings about 401(k) plans while increasing their employees’ use of the plan, while helping their employees reach their retirement goals.

If you’re interested in discussing your company’s 401(k) plan administration, click here to set up a time to discuss.