A 401(k) plan is a US-specific retirement account offered by companies to their employees. The account moves some of an employee’s pre-tax income to a tax advantaged account that invests in different securities. Investments tend to be made by the employer on behalf of their employees.
Companies aren’t obligated to offer 401(k) plans, but because employees strongly value these plans they can be a great way to attract and retain talent.
Payment execution platforms may also sometimes offer 401(k) plans as part of their services.
What are the different types of 401(k)s?
Two of the most common types of 401(k) accounts are ‘traditional’ and ‘Roth’, but there are a few more that are worth mentioning:
Traditional 401(k) plan: These are the most common type of 401(k) plan. Employees make pre-tax contributions from their salaries, and employers match these contributions.
Roth 401(k) plan: Here, employees make after-tax contributions, rather than pre-tax contributions. That means they don’t owe taxes once they withdraw for retirement.
Automatic Enrollment 401(k) plan: Employees are automatically enrolled in this plan but can opt out at any time. The automatic contribution increases over time.
Safe Harbor 401(k) plan: Employers must make contributions to their employees’ retirement accounts, either as elective or matching contributions. Safe harbour plans make it easier for employers to pass compliance tests.
Non-Qualified 401(k) plan: This type of account is not subject to the same IRS requirements as traditional 401(k)s, and that means they can provide extra benefits to employees. These accounts are commonly used by highly compensated employees.
Solo 401(k) plan: These types of 401(k)s are specifically for self-employed people or small business owners. These accounts give higher contribution limits and more investment options compared to other account types.
How do 401(k) accounts work?
Each type of 401(k) tends to differ in how it works, but in general the process can look something like this:
A portion of an employee’s salary (usually pre-tax but not always) is set aside in their 401(k), per their preferences. The employer might also then add to this account, either matching the contribution or through a non-elective contribution.
The funds will then typically grow tax-free until withdrawn for retirement.
Employees will usually have control over how much they want to contribute to this account and where they want to invest. Employees can also choose to pull the funds before retirement age, but this can result in tax penalties and implications.
What happens to an employee’s 401(k) if they leave their job?
If an employee leaves the company, they have a few choices of what to do with their 401(k) plan:
- Keep it in the account, but without the ability to further contribute to it
- Roll it into their new company’s 401(k) plan
- Withdrawing the funds early is also a possibility in some cases but, as mentioned, can result in tax penalties and other implications.
How should non-US-based companies handle 401(k)s?
For companies operating from outside the US, providing US-based employee 401(k)s can be a complicated undertaking, with regulatory hurdles and IRS-pressed considerations galore.
In this case, payment execution platforms can be a big help providing global payroll, and including assisting in things like compliance and reporting.
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