Since 1999, our mission at Ubiquity Retirement + Savings™ has been to make it easy for small business owners to design and execute a cost-effective 401(k) saving strategy. Here is our guide to what you need to know about 401(k):
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A 401(k) is a savings vehicle established by a business or self-employed person to help employees and business owners save for retirement as well as take advantage of the tax benefits provided to both the business owner and employees. The flexible features of a 401(k) can accommodate the needs of a broad range of retirement planning objectives. Each individual gets to choose how much of their pay will be deposited into their 401(k) account each pay period – before taxes are deducted and how those dollars will be invested. Many businesses choose to match a portion of the employees’ contributions, helping retirement savings grow even faster.
In addition to providing financial security in retirement, saving in a 401(k) provides tax advantages for both the business owner and the employees, including tax deductions, tax-deferred earnings, and tax credits. For example, when an employee saves in a 401(k), their contribution is deducted from their paycheck before income taxes are withheld. These pre-tax contributions lower an individual’s tax liability for the year, just for investing in their future.
Many 401(k) plans allow employers and employees to contribute funds to their 401(k) in two ways: as a pre-tax contribution, and as a Roth 401(k) contribution. Roth 401(k) contributions are made with after-tax dollars. When an employee takes money out of their 401(k), those contributions and the investment earnings made are tax-free if the employee meets certain requirements.
To qualify for tax-free distributions, the individual must have a Roth 401(k) account for at least 5 years and be 59½ or older, disabled or deceased. Roth 401(k) is a big advantage for those who are concerned about the tax changes that may occur in the future. With a Roth 401(k), individuals and employers will not be taxed on an uncertain tax future.
A 401(k) must pass certain nondiscrimination tests each year that are designed to prevent the 401(k) from primarily benefiting high-earning individuals. If a 401(k) fails these tests, an option for the small business owner is to adopt a Safe Harbor 401(k) plan.
A Safe Harbor 401(k) can bypass the tests in exchange for specified employer contributions that are fully vested. When an employer chooses a Safe Harbor 401(k), the owners and high-earning individuals will be able to maximize their 401(k) contributions instead of being limited by the amount lower-paid employees contribute to the 401(k).
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401(k) plan guide
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Many employers make additional contributions to their employees’ 401(k) plan accounts to help their employees reach their retirement planning goals faster, while also taking advantage of additional tax benefits for their business.
The most common employer contribution is a match on a portion of the dollars an employee puts into the plan – for example, an employer may choose to contribute $1 for each dollar the employee contributes, up to the first 3% of the employees’ pre-tax pay. Employers, including self-employed individuals, also sometimes make discretionary profit-sharing contributions to their employees.
For 2023, you can save up to $22,500 of your pay in a 401(k) ($30,000 if you’re age 50 or older).
In addition, the business may make matching or profit-sharing contributions. Employee contributions, combined with any employer contributions, cannot be greater than the employee’s income for the year, up to a maximum of $66,000 for 2023.
Tax laws require 401(k) plans to pass nondiscrimination tests each year to make certain the 401(k) is not primarily benefiting high-earning individuals within the company. The IRS wants to ensure that plans that are being established within an organization are fair and balanced, hence the name, nondiscrimination testing. If lower-paid individuals are not making significant contributions, high-earners and business owners may not be able to maximize their contributions.
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An Individual Retirement Account or IRA is another type of retirement savings vehicle. IRAs are set up by an individual, usually independent of their employer, and are funded by the individual as an additional way to save money toward their retirement planning goals.
IRAs can also receive rollovers of assets from other retirement savings vehicles like 401(k) plans. A 401(k), on the other hand, is established by a business or self-employed individual. A 401(k) plan can accept both employer and employee contributions. Successful savers can use an IRA plus a 401(k) if their employer offers the 401(k) option.
401(k) plans generally offer a broad range of investment options. These options are typically selected by the business that sponsors the 401(k). Most 401(k) plans allow employees to choose their own investments from what the business owner (also known as the plan sponsor) selected for the 401(k). Some 401(k) plans provide investment and advisory services to employees. Understanding the risk versus return of the investment fund is important.
Employees who save in a 401(k) contribute a portion of their pay each pay period. Employers must deposit that pay into employees’ 401(k) accounts as soon as possible after each payroll date. Many employers also fund matching contributions each pay period but have until the business’s tax return due date to make employer matching and profit-sharing contributions to the company 401(k).
As a part of the retirement planning process, individuals should consider using a retirement calculator to help them estimate how much money they need to save to reach their savings goals and retire comfortably.
These tools help individuals estimate what their 401(k) balance will be at retirement, depending on their current 401(k) contribution rate, plus expected Social Security benefits, any employer matching dollars, or additional savings an individual may have saved. We recommend only calculating those funds that you control, like your 401(k) or other savings. The future of Social Security benefits has been debated for many years, and depending on when you retire, may not provide a consistent payout.
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When individuals stop working for the business sponsoring the 401(k), they typically have four options regarding their 401(k) savings. They can choose to leave their savings in that 401(k), roll over (move) their money to another 401(k), roll over their money to an IRA, or take a cash distribution of their savings.
If an individual dissolves their 401(k) and takes the cash, it’s counted as income that year and taxed because the contributions were not taxed when deposited into the 401(k). You will be taxed for the contribution and all the interest earned unless your 401(k) was set up as a Roth, or after-tax plan. Many individuals choose to roll their 401(k) money directly into an IRA or into a 401(k) offered by their new employer. Expert advice: Look at the investment choices available to you and the fees associated with the plan or IRA before making any moves.
In saving for retirement, tax laws are designed to discourage savers from taking money out of a 401(k) before they retire. Money can only be taken out of a 401(k) after certain events occur such as leaving employment, disability, and retirement. Many 401(k) plans allow individuals to take a withdrawal before retirement if they are experiencing a financial hardship. Distributions took before an individual reaches retirement age may be subject to early distribution taxes as well as income taxes.
If someone reaches age 73 and still has money in their 401(k), they must begin taking a minimum payment each year until the account is depleted.
Some 401(k) plans provide exceptions for older workers who are still employed. When the 401(k) participant dies, the person(s) they named as beneficiary generally must continue taking payments out of the 401(k).
Sometimes individuals have a financial emergency or need for more money than they have on hand. Most 401(k) plans allow the business owner and employees to take a loan from their 401(k) account and pay back the loan, with interest, through payroll deductions.
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