401(k) plans feature a range of options, including plan design types and features
Many options come with different contribution limits and varying degrees of administrative work
Let’s review 401(k) plan design types and options so you can help decide what makes the most sense for your business
On the surface, the prospect of starting a 401(k) plan for a small business may seem intimidating. This type of retirement plan features a range of options, including plan design types and features that can affect contribution limits for your employees and administrative work as a small business owner. The wide range of employer-sponsored 401(k) plan types can be confusing. But we’re here to help.
This guide will cover 401(k) plan design types and options that make the most sense for small to medium businesses—and will break down the specifics to help you decide which might be best for you. Often, the size of your business can help determine which type of plan design may be best for your business and your team.
We’ll start with discussing options available to you in a 401(k) plan:
Differences between traditional and Roth 401(k) deferral types
Employer matching and profit sharing
Safe harbor provisions
Some small businesses like sole proprietorships have different needs—so we’ll also cover these common alternatives to 401(k) plans:
What is a 401(k) plan?
A 401(k) is an employer-sponsored retirement plan that allows employees to contribute a percentage of their salary directly to a designated retirement account. Contributions to the 401(k) account are invested in a portfolio made up of mutual funds, stocks, bonds, and other investment options chosen by the individual from a set of options determined by the plan sponsor or a qualified investment manager.
|401(k) type||Generally a good fit for||Employer contribution required?|
|Traditional 401(k)||Businesses that are looking to scale their employee headcount, or want the flexibility to offer other retirement benefits.||No|
|Roth 401(k) deferrals (add on feature for 401(k) plans)||Businesses that want to offer a second way for their employees to contribute to their retirement savings. There are also no income limits.||No|
|Safe harbor 401(k)||Businesses that want to automatically pass some key Internal Service Revenue (IRS) nondiscrimination testing.||Yes|
|SIMPLE 401(k)||Small businesses with less than 100 employees that want to offer a plan with less stringent IRS requirements.||Yes|
|Solo 401(k)||Self-employed individuals or owner-only businesses including spouses.||N/A|
Benefits of a 401(k) plan
Major benefits of a 401(k) plan include saving for retirement and saving on taxes. Because of the convenience of having money deducted directly from their salary (also called a “deferral”), employees are more likely to save for their retirement if their employer offers a plan. In 2021, 75% of private-sector workers whose employers offered some kind of retirement benefit participated in it.
According to a survey commissioned by Human Interest and conducted by OnePoll in March 2022, retirement plans are the second most-wanted benefit after health insurance. So, offering a 401(k) plan may bolster a business’s hiring and retention, particularly among younger workers.
To encourage participation in retirement plans, both individual employees and their employers can save on taxes through their contributions to 401(k) plans
Traditional 401(k) deferrals (pre-tax)
All 401(k) plans must allow eligible employees to contribute deferrals from their paycheck on a pre-tax basis. This means the employee’s deferral money goes into their 401(k) account before federal and state taxes are taken out. Contributions are often set at a percentage of an individual’s salary but can be a predetermined dollar or percentage if the plan document allows. Pre-tax deferrals delay income tax on contributions until they’re distributed. The idea behind pre-tax deferrals is that participants will often be in a lower tax bracket at retirement.
Contribution limits for a traditional 401(k) plan
The maximum deferral amount that an employee can contribute to a traditional 401(k) plan is $22,500 for 2023. Employees aged 50 or above can contribute an additional $7,500 to an account as a catch-up contribution, making the limit $30,000 for those closer to retirement.
Advantages of traditional 401(k) plans
Some benefits of a traditional 401(k) plan include:
Higher contribution limits compared to SIMPLE plans.
No maximum number of employees. Your business can scale without needing to change plans—one way to avoid administrative headaches down the road.
Flexibility. The traditional 401(k) can be offered alongside other types of retirement plans (e.g., pension plan or target benefit plan), allowing businesses more diversity and flexibility in their offerings.
Vesting schedule. Employer contributions can become vested over a period of up to six years, depending on plan design.
Disadvantages of traditional 401(k) plans
The major drawbacks of traditional 401(k) plans are:
Choosing from an ever-increasing number of complex plan options.
Ongoing administrative maintenance in the form of required IRS nondiscrimination testing, which is something all traditional 401(k) plans must undergo. These tests are designed to ensure that plans do not unfairly favor highly compensated employees.
For employees, traditional 401(k) plans have required minimum distributions starting at age 72 (or later if the withdrawal can be deferred until retirement).
Roth 401(k) deferrals (post-tax)
401(k) plans can also allow participants to contribute Roth deferrals. Rather than paying taxes on the contribution at the point of withdrawal, Roth contributions are made on an after-tax basis (also known as a post-tax deduction). That means the amount of the contribution is determined after federal and state taxes have been taken out.
Taxes are paid from the employee’s gross pay before the contribution is deposited in the retirement account from the employee’s take-home pay. This way, the employee doesn’t pay taxes on their deferrals when the funds are later withdrawn during retirement. Earnings on deferrals may or may not be taxable depending on certain requirements being met. The idea behind Roth deferrals is that the participant will not pay taxes on earnings made on their contributions (assuming certain requirements are met) and will not have to pay taxes on distributions during retirement.
If a plan chooses to add a Roth deferral component, the amount the participant can contribute to the plan still totals $22,500 for 2023 plus $7,500 in eligible catch-up contributions. This limit is the sum of both pre-tax and Roth deferrals.
Advantages of a Roth 401(k) deferrals
Roth 401(k)s can be good options for those whose taxes are likely to go up in retirement because the rate at which they’re paying taxes now is likely to be lower. Other advantages include:
No income limits like Roth IRAs.
Contribution limit for a Roth 401(k) is much higher than for a Roth IRA.
Individuals can contribute to both a Roth 401(k) and a traditional 401(k).
Disadvantages of a Roth 401(k) deferrals
The major drawbacks of Roth 401(k) deferrals include:
Like traditional 401(k)s, Roth 401(k) deferrals have required minimum distributions starting at age 72 (unless the withdrawal can be deferred until retirement), unlike Roth IRAs.
Employer contributions in a 401(k) plan
Employers can make contributions to their 401(k) plan as well. These employer contributions can be as either profit-sharing contributions (meaning all eligible employees receive a contribution, even if they are not making employee deferral contributions into the plan), or as matching contributions (meaning only eligible employees who are making deferral contributions into the plan get an employer contribution based on a matching formula). The 401(k) plan document will cover which employer contributions are allowed in the plan, how they are allocated, and to whom they are contributed. Employers may receive a tax deduction for their contributions to the plan.
The most common employer contribution in a 401(k) plan is a match. Employers can choose to match a portion of the employee’s deferral contributions up to a certain dollar or percentage. A matching contribution also encourages employees to participate in the plan, which can have positive effects on required annual non-discrimination testing.
Profit-sharing is not actually tied to an employer’s profitability, despite its name. This optional employer contribution is provided to all eligible employees—regardless of their deferral election—and is based on annual compensation. Businesses of any size can offer profit-sharing plans and there are numerous allocation formulas an employer can choose, depending on their goals. Any profit-sharing contribution must be allocated to eligible participants using a definite, predefined allocation formula that’s stated in the plan document. An employer can make a contribution in any year, even an unprofitable one.
A profit-sharing plan may be a free-standing plan or a profit-sharing feature can be included in a 401(k) plan.
Vesting in a 401(k) plan
Employee deferral contributions are always 100% vested immediately, meaning the contributions always belong to the employee. Employer contributions made under a safe harbor plan (discussed below) are also typically 100% vested immediately.
Employer contributions such as non-safe harbor matching contributions and profit sharing contributions can be subject to a vesting schedule as long as six years, which allows participants to receive ownership in their employer contributions over a period of time, which can result in higher employee retention.
What is a safe harbor plan?
A safe harbor 401(k) plan is a type of 401(k) plan that is designed to automatically satisfy some IRS annual nondiscrimination testing requirements. In exchange for simpler testing, the employer must agree to make mandatory employer contributions. The mandatory employer safe harbor contribution may be in the form of a match or nonelective (profit sharing) contribution.
Contribution limits for safe harbor 401(k) plans
The employee contribution limits are the same as for traditional 401(k) plans: $22,500 for 2023, plus a $7,500 catch-up contribution for those 50 and older. The safe harbor provisions allow business owners and highly compensated employees to maximize their annual deferrals without failing nondiscrimination testing.
Advantages of a safe harbor 401(k) plan
Employees are immediately 100% vested in employer safe harbor contributions.
Owners and highly compensated employees can contribute the maximum amount to their 401(k) plans without having to worry about refunds due to failed nondiscrimination testing.
Disadvantages of a safe harbor 401(k) plan
Employers must abide by strict safe harbor deadlines.
Employers must commit to the safe harbor plan design for the entire plan year.
Employer contributions can be expensive, depending on employees’ salaries; which means that the plan type may be tailored to businesses with a strong cash flow.
To see how much a safe harbor plan might cost your business, try our safe harbor calculator.
401(k) plan alternatives for small businesses
While one of the 401(k) types above will work for many employers looking to help their employees save for retirement, sometimes, small businesses need something different. For sole proprietorships or businesses with fewer than 100 employees, there are additional retirement plan options.
SIMPLE 401(k) plans
Like the traditional 401(k), the SIMPLE 401(k) plan offers flexibility in determining who’s eligible to participate in the plan and is required to file a Form 5500. However, the SIMPLE 401(k) has rules that allow it to avoid the nondiscrimination testing that apply to traditional plans. These include:
A 100-employee limit.
Employers who offer a SIMPLE 401(k) cannot offer other qualified retirement plans.
Annual notice requirements.
Mandated employer contributions with 100% immediate vesting.
Calendar year requirements.
Contribution limits for a SIMPLE 401(k)
In 2023, the annual maximum employee contribution limit for a SIMPLE 401(k) plan is $15,500 (with catch-up contributions of $3,500 permissible for employees age 50 and over).
Employer contributions required in a SIMPLE 401(k) plan
Employers are required to make a matching contribution of 100% on the first 3% of compensation deferred. Alternatively, employers may make a nonelective contribution of 2% of calendar year compensation (compensation is capped at $330,000 for 2023) for all employees who earn over $5,000 in compensation for the year. SIMPLE 401(k) employer contributions must be immediately 100% vested.
Advantages of a SIMPLE 401(k)
A cross between a traditional 401(k) and an IRA, the SIMPLE 401(k) can work well for the right small business.
No testing. Employees may contribute up to the full deferral limit and employers do not have to worry about unexpected contributions due to failed testing. Eliminating compliance testing also reduces administrative costs for employers.
Flexible eligibility. This may reduce the cost of employer contributions when compared to the SIMPLE IRA.
Flexible distribution opportunities. SIMPLE 401(k) plans may allow loans and in-service distributions similar to a traditional 401(k).
Disadvantages of a SIMPLE 401(k)
Mandatory employer contributions every year.
Lower contribution limits compared to traditional 401(k) plans.
Strict size restrictions. Growing businesses may outgrow a SIMPLE 401(k) plan quickly. (The employer can amend a SIMPLE 401(k) to become a traditional 401(k), which may save some time and resources on making new retirement plan decisions.)
The “exclusive plan rule” prevents employers from sponsoring another qualified plan.
Solo 401(k) plans
A solo 401(k), also known as a one-participant 401(k) plan, can be a great option if you're a sole proprietor. If you see yourself expanding your business to hire other employees, you can amend a solo 401(k) to a traditional 401(k) at any time. A spouse who earns compensation from the business may also participate. If the employer has other eligible employees, it is not eligible for a solo 401(k).
Contribution limits for solo 401(k) plans
The contribution limit for a solo 401(k) is the same as a traditional 401(k); $66,000 in 2023 with catch-up contributions up to $7,500 for those 50 and older. This total includes employee elective deferrals and employer contributions. The limit for elective deferral contributions is $22,500 per person ($30,000 for those age 50 and up).
Advantages of solo 401(k) plans
Higher contribution limit (and tax deductions) than a SIMPLE plan or IRA
Available for some part-time or freelance work as well as full-time businesses (though having multiple retirement accounts may affect the contribution limit for the solo 401(k))
Disadvantages of solo 401(k) plans
Employers sometimes forget to amend their solo 401(k) when their business grows. This can be expensive to fix.
Depending on who administers your solo 401(k) plan, there can be more administrative work, which can result in higher fees. To learn more about these plans, read our tips on solo 401(k)s.
Deciding on a 401(k) for your business
Finding the right 401(k) plan for your small business and its employees may be overwhelming. In addition to the various types of plans, almost every financial company offers some kind of 401(k) option, and financial advisers are competing to help you start a 401(k) or similar retirement plan.
Human Interest specializes in helping small- and medium-sized businesses choose and set up a 401(k) for their employees. We provide low-cost options designed to help your small business employees save for retirement while helping your small business take advantage of tax benefits and help keep costs and administrative work to a minimum.
Article ByThe Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.