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What is a 401(k) Plan and What Does HR Need to Know?

What is a 401(k) Plan and What Does HR Need to Know?

A 401(k) is a tax-free retirement savings account that many employers offer to employees as an employee benefit. These accounts allow employees to deposit pre-tax income into a savings account that can only be used once an employee has reached the age of retirement. Many employers choose to contribute to these plans depending on the employee's contributions. 

 

When Can Employees Withdraw From Their 401(k)?

The IRS requires employees to be at least 59.5 years old (55 years old if you leave your employer) to withdraw funds from their 401(k) penalty-free. This ensures that employees uses these tax-free accounts for retirement. If an individual chooses to withdraw from a 401(k) before they reach the age of 59.5 years, they will be responsible for paying:

  • Federal income tax  
  • State income tax (if applicable)
  • 10% penalty 

Of course there are exceptions. Some 401(k) plans allow employees to make 401(k) hardship withdrawals. Learn more.

What's the Most Common 401(k) Match? 

According to data published by Vanguard, the most common 401(k) structure is the simple match formula, a plan in which the employer matches a percentage of the employee's contribution up to a certain threshold. A few notable 401(k) match data points:

  • The average employer matching contribution equals 4.3% of an employee's salary
  • The most common match equals 50 cents for every $1 the employee contributes up to 6% of employee's salary
  • Other employers match $1 for every $1 the employee contributes up to 3% of employee's salary

 

401(k) Plan Contribution Limitations

Each year, the IRS establishes restrictions on how much employers and employees can contribute to 401(k) plans each year. In 2021, employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan may only contribute $19,500 to these accounts.

However, the IRS announced that a $1,000 increase in maximum contributions from all sources, which include employee and employer contributions. In other words, the employer contribution cap increased by $1,000, setting the maximum defined contribution limit at $58,000.

 

When Should Employees Be Eligible for 401(k) Plans?

Some companies—typically smaller organizations—require employees to work for a year before they become eligible to participate in the company's 401(k). This delayed 401(k) option can be less attractive to quality job candidates.

Other companies automatically enroll employees in the plan, but require a waiting period for the employee to be able to receive employer contribution. The most generous 401(k) plans automatically enroll employees in the plan upon the employee's first paycheck and require no waiting period for an employer contribution to kick in. 

When choosing between these three options, employers must evaluate their financial standing. If a company has more budgetary restrictions, it may be best to require a full year of employment before an employee becomes eligible to participate in the company's 401(k). 

Once you evaluate your financial flexibility, consider your organization's turnover rate, employee satisfaction, and ease of hiring. If these are weak points for the company, you could consider offering one of the automatic 401(k) enrollment options. 

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