401k: What Is It and How To Setup One

May 4, 2023
The retirement savings opportunities provided by 401(k) programs can be substantial. They help both the company and its workers, making them a worthwhile consideration for any company looking to set up a retirement plan. Keep reading to learn more.

What is a 401k?

401k is a retirement savings plan available to most American employees and gives the saver tax advantages. It has roots in the original Internal Revenue Code (IRC) that allows such contributions to be tax-free until the person starts withdrawing the income in retirement.

An employee who sets up a 401k agrees that a percentage of their payment will be remitted directly to an investment account. The employer could match the contribution or part of it.

Employers can benefit from a 401(k) plan in a number of ways;

  • Contribution amounts are set by the individual and not the program.
  • Allows businesses to write off their donations to their workers' funds
  • Helps both the management and the regular staff.
  • Allows the money to expand through investments in things like equities, bonds, mutual funds, money market funds, savings accounts, and so on.
  • Offers substantial financial benefits
  • Reduction in managerial burden as members are free to take their perks with them when they depart the business.

The 401(k) Plan Setup Procedure

It's important to remember the fundamentals when setting up a 401(k) account. You'll need to decide early on whether to set up the plan on your own or seek the assistance of an expert or financial organization like a bank, mutual fund provider, or insurance business. Initiating a 401(k) plan entails the following four measures:

  • Create a formal strategy in writing.

A written record that lays the groundwork for regular planning activities is the first step. If you've engaged a consultant, he or she will likely deliver the required paperwork. If you need help, consult a bank representative or an expert on retirement plans. The plan document's conditions will apply regardless of the outcome. Choosing between a conventional 401(k) plan, a safe harbor 401(k) plan, and an automatic registration 401(k) plan is the next step after deciding on a 401(k) plan. Salary withdrawals are an option for all of the options detailed below.

The most adaptable option is the classic 401(k). Employers have the option of making a universal contribution, matching employee deferrals neither, or both. The right to receive company payments may become non-forfeitable only after a specified period of time, according to a tenure plan. Benefits for regular workers have been compared annually to those for upper-level executives to guarantee equity. It's important to note that not all 401(k) plans are susceptible to the requirement of the yearly payment. In return for not having to be tested every year, workers in safe harbor 401(k) accounts must receive a minimum amount of money from their employers. Employer payments that are required under the most common safe harbor 401(k) plan must immediately become completely vested.

Unless the employee specifies otherwise, their wage contributions can be immediately invested in a predetermined set of preset assets as part of a 401(k) plan. This is a great strategy for encouraging more employees to contribute to their companies' 401(k) programs. All companies, no matter how big or small, can take advantage of the standard, safe harbor, and automated registration programs. After settling on a plan's general structure, your business can tailor specifics such as which workers are eligible to pay and how much they can put in. Some of the provisions of the strategy must be included by legislation. The planned paper should outline the process by which donations are put into the plan, for example.

  • Plan assets should be placed in a trust.

It is imperative that the assets of a plan be kept in trust for the singular advantage of the members and their heirs. Contributions, plan assets, and payments can only be managed by a designated administrator. One of the most crucial steps in creating a 401(k) plan is choosing an administrator who will be responsible for safeguarding the plan's assets. Insurance arrangements can be used to establish a strategy without necessitating trust.

  • Create a method of maintaining tabs on things

All of the money that goes into the plan, as well as any returns it receives, the money it invests in, the money it spends, and the money it hands out in benefits, must be recorded accurately. If a third party, such as a contract organizer or financial organization, is involved in the management of the plan, they will likely aid in maintaining the necessary documents. In addition, a recording system will be useful in preparing the yearly return/report that must be submitted to the Federal Government by you, the planning organizer, or the financial source.

  • Disseminate plan details to qualified staff

Certain characteristics, privileges, and advantages of the plan must be communicated to qualified workers. In addition, a summary plan description (SPD) must be made available to each individual. The SPD is the main means by which plan members and recipients receive information about the plan and its administration. It's made in tandem with the blueprint paper most of the time. It's also a good idea to brief workers on the benefits of the 401(k) plan you're offering. Employee payments to a 401(k) plan are deducted from pay before taxes are calculated (or earned, in the case of Roth contributions), and profits grow tax-deferred if the company also contributes (which they can choose to do).

Managing a 401(k) Pension Scheme

You take on certain obligations once you launch a 401(k) plan. The services of a plan administrator may have been contracted for in addition to those of a plan designer. The alternative is to employ an expert or financial entity like a bank, mutual fund provider, or insurance business to handle some or all of the aspects of running the plan on your behalf.

401(k) plan components include:

  • Participation

Plans typically include both regular workers and higher-ups. Employees under the age of 21, those with less than one year of employment, those covered by a collective bargaining agreement whose retirement benefits were the topic of good faith negotiations, and certain foreign immigrants may be ineligible to participate in a 401(k) plan.

  • Contributions

Salary withdrawals are an option in all types of 401(k) programs. The amount of money that your company puts into the funds of the plan's members is up to you.

Traditional 401(k) Scheme

Non-elective contributions are those made by employers as a fixed proportion of workers' salaries while matching contributions are those made by employers in response to employee contributions. Employer payments to the 401(k) plan are provided only to workers who make deferrals using a reciprocal contribution calculation. Each qualified employee will receive the company added to the 401(k) plan if non-elective donations are made, regardless of whether or not the employee chooses to make a wage deferment. Employer payments to a conventional 401(k) plan can be adjusted annually to reflect changes in the company's financial situation.

Safe Harbor 401(k) Plan

Each qualified employee's donation can be matched up to 3 percent of their salary, dollar for dollar, under a safe harbor scheme, and up to 5 percent of their compensation, 50 cents on the dollar. Alternatively, you can make a mandatory donation to each qualified employee's account in the amount of 3% of their salary. Either equal donations or non-elective contributions are required each year. Contribution amounts and timing will be outlined in the plan paper and communicated to workers well in advance of the new year.

Put Money in a Roth IRA

Salary deducted 401(k) payments are investments made by workers after taxes have already been taken out. These donations, as well as any profits or losses associated with them, are tracked in a manner distinct from pretax contributions. Donations that are marked as Roth are taxed differently than pretax donations but otherwise operate under the same rules and restrictions as a traditional 401(k) plan. Participants in a 401(k) plan may have the option of moving funds from their traditional 401(k) account to a Roth 401(k) account.

Restriction on Donations

There is a yearly cap for each worker that applies to both company and employee payments and forfeitures (unvested employer funds of dismissed workers). This cap is set at the lower of $57,000 in 2020 or $58,000 in 2021 of the employee's total pay. Furthermore, in 2020 and 2021, the maximum 401(k) contribution that an individual can make is $19,500. Both pretax wage deferrals and Roth donations made by employees are included. (if permitted under the plan). For 2020 and 2021, workers aged 50 and up may contribute an additional $6,500 to their 401(k) accounts.

  • Vesting

Salary deferrals made by employees are fully vested the moment they are made, meaning that they cannot lose any of the money they've put into the plan. Those deferrals, plus financial gains (or negative losses) on the deferrals, are payable to the employee upon termination of employment. All mandatory company payments to safe harbor 401(k) accounts are fully paid at the time they are made. Employer payments to a conventional 401(k) plan can be made to accrue in increments over time.

  • Nondiscrimination

In order to keep its financial advantages, a 401(k) plan must provide meaningful rewards to all workers, not just the company's upper echelons. Nondiscrimination regulations demand a comparison of the plan involved and payments between owners/managers and regular workers. A yearly evaluation is performed on traditional 401(k) plans to guarantee that the amount of payments made for regular workers is proportionate to the amount made for proprietors and managers. The yearly nondiscrimination testing requirement does not apply to safe harbor 401(k) accounts.

  • Making investments with the contributions

The many 401(k) financial choices are available after the plan form has been selected. When creating a plan, you'll need to choose whether to give workers financial control over their own funds or to take on that responsibility yourself. If you go with the former, you'll have to think about what kinds of investments to offer the members of the plan. You may need to employ an investment expert or an investment manager, depending on the structure of your plan. Keep an eye on the financial choices you've made to make sure they're still serving the needs of your plan and its members.

  • Rights and Duties as a Trustee

Fiduciary choices are required for many of the steps required to run a 401(k) plan. This holds true regardless of whether you outsource plan administration or handle it all on your own. To the degree that you or the company you employ have authority over the plan's funds or manage the plan's day-to-day operations, you are a plan trustee. If you charge clients for financial guidance, you are a trustee. The act of hiring a trustee is itself a fiduciary deed. Therefore, fiduciary's standing depends on the duties they undertake on behalf of the plan and not on their job designation. There are some plan decisions that should be treated as business choices rather than ethical ones. Establishing, implementing, modifying, and discontinuing a strategy are all examples of business judgment calls. You are not a trustee if you make these choices because you are representing your company and not the plan. But when you (or those you employ) take action to put these choices into effect, you are operating on behalf of the plan and maybe a trustee.

  • Participant information disclosure

Disclosure papers provide plan members with the information they need to understand the plan's fundamentals, be notified of any changes to the plan's structure or operations, and make educated, prompt choices regarding their funds.

  • Providing Information to Authorities

Plans must submit certain information to Government organizations in addition to the transparency papers that provide information to members.

  • Benefits distribution

In a 401(k) plan, a participant's payout sum is determined by the value of their account when payment is made. When a 401(k) member becomes qualified for distribution, the plan may allow them to choose between a single sum payout, a rollover to an individual retirement account (IRA) or another employer's retirement plan, or regular payouts. More and more defined contribution plans include pension or other lifelong income distribution choices for workers who want to make sure they don't run out of money in retirement. You could see what other companies are doing to see what works best for you.

Terminating a 401(k) Plan

A 401(k) plan must be sustainable indefinitely to be legitimate. However, a business may need to abandon the program if doing so solves operational problems. It's possible, for instance, that you'd rather create a supplementary retirement plan than participate in a 401(k). Changing the plan document, distributing any surplus assets, and filing a final Form 5500/Report of Employee Benefit Plans are the usual steps involved in winding down a 401(k) plan. In addition, you must notify your employees that the plan will soon be ending. Determine what else must be done to formally close your 401(k) plan by consulting with the plan's financial institution or a retirement plan specialist.


Setting up a 401k is the right step toward securing your financial stability in retirement. Most employers help their staff by either matching a part of the 401k or all of it. As you initiate your 401k, you need to take up the services that follow it.