What is a 401(k)? A Beginner’s Guide

A 401(k) is a retirement savings plan sponsored by an employer. Named after Section 401(k) of the U.S. Internal Revenue Code, it allows employees to save and invest a portion of their paycheck before taxes are taken out.

Employers can also contribute to the plan, often through matching contributions, which significantly enhance the employee's savings.

Retirement savings weigh on the minds of employees and employers alike. For employees, retirement savings are crucial to their long-term financial security. And for employers, retirement savings and pensions are crucial to ensuring they attract and retain the best employees.

In the United States, the 401(k) plan is one of the most widely used retirement saving tools, offering benefits to both employees and businesses.

But we imagine you’ll likely have a lot of questions about a 401(k) offering. While 401(k)s are well known, they’re not necessarily well-understood.

So if you’re managing a team in the USA, this guide will guide you through the benefits of 401(k) plans, the key features, the different types of 401(k)s available depending on your business model, and why a good 401(k) plan can be key to employee retention.

What are the different types of 401(k)?

There are a number of different employer-sponsored 401(k) plan types that an employee can choose from, including:

• Traditional 401(k) plan
• Safe Harbor 401(k) plan, including Qualified Automatic Contribution Arrangements
• SIMPLE 401(k) plan
• Roth 401(k) plan

Let’s take a look at each of these individually.

Traditional 401(k) plan

With a traditional 401(k) plan, the contribution amount is deducted on a pre-tax basis. It’s most popular with employees who wish to be in a lower marginal tax bracket when they retire.

When 401(k) plans were first introduced in 1978, traditional 401(k) plans used to be the only defined contribution plan available.

An employee's savings are not taxed until they decide to cash out, which is often during retirement. This will be at ordinary income rates which reduces their income taxes.

If you do choose to have a traditional 401(k) plan, you should be aware there is a mandatory requirement to conduct yearly non-discrimination tests.

This ensures contributions aren’t only favourable for your high-earning employees (considered as any employees you have earning over $150,000 (USD) per annum and/or they own more than 5% of the employer (either directly or by family attribution) at any time during the year being tested).  

Your business needs to pass the Actual Contribution Percentage (ACP) and the Actual Deferral Percentage (ADP) tests. If your business fails the test, you may potentially be required to refund contributions to your high-earning employees.

Safe Harbor 401(k) plan

Safe Harbor 401(k) is the most popular 401(k) retirement plan type and constitutes more than 68% of all 401(k) plans in the USA.  

It is perhaps the most popular type of 401(k) plan as there is no requirement to undertake the yearly non-discrimination tests by meeting certain contributions and participant notice requirements.

This reduces your administrative burden and ensures compliance.

There are two basic forms of Safe Harbour 401(k) plans (yes, we know, it can feel complicated)

The first type is Traditional Safe Harbour 401(k). The second is known as a Qualified Automatic Contribution Arrangements (QACAs).

Both are very similar, but the biggest twist with the QACA is it has the automatic enrolment feature built in, and must include automatic escalation of employee contribution rates.  

With the introduction of auto enrolment from 1 January 2025 for all 401(k) plans set-up since 29 December 2022, QACAs are likely to become more common. For a  Traditional Safe Harbour 401(k), you have two choices on how to make contributions:

1. 3% Non-elective: Contribute 3% of every eligible employee's pay to the 401(k) without the requirement for the employee to make a contribution
2. 4% Match: The traditional safe harbor match is a 100% match on the first 3% of an employee’s contribution and a 50% match on the next 2%.  This is the most common strategy.

All contributions (yours and your employees) must also be 100% vested immediately.

QACAs require that you contribute either a 3% non-elective contribution or match 100% of the first 1% of compensation deferred and 50% of deferrals that exceed 1% of compensation, not to exceed 6% of compensation.  

Differing from the Traditional Safe Harbour 401(k), QACA employer contributions may be subject to a 2-year cliff schedule.

Roth 401(k) plan

The Roth 401(k) plan is a post-tax deductible plan that arrived in 2006, and can be offered by businesses of any size.

The employee contributions towards a Roth 401(k) plan aren’t tax-deferred. They’re made with after-tax dollars. Savings will grow tax-free throughout the years with a Roth plan. Your employee won’t have to pay taxes on their withdrawals or investment earnings when they retire.

Overall, the after-tax dollars Roth 401(k) plan is a great option for those who believe they’ll be in a higher tax bracket after retirement.

SIMPLE 401(k)

SIMPLE 401(k) plan stands for the Savings Incentive Match Plan for Employees. It’s designed for business owners with 100 or fewer employees.

There is a mandatory requirement for businesses to contribute to a SIMPLE 401(k), with the choice of either a match up to 3% of the employee’s pay or a 2% non-elective contribution for every eligible employee.

The contribution limits to a SIMPLE 401(k) are less than for a Traditional 401(k). For 2025, the contribution limit is USD 16,500 for individuals under age 50. Those aged 50 and older can contribute an additional USD 3,500 in catch-up contributions

The SIMPLE 401(k) plan is a good option if you are a business that aims to expand in the future due to a two-year grace period for exceeding 100 employees, allowing the business time to determine which retirement plan will best suit its business model.

Understanding the basics of a 401(k) plan

Employee contributions

Your employees will contribute to their 401(k) plans through payroll deductions. These contributions can be either pre-tax or post-tax, depending on the type of plan and the employee's preference.

Employer matching

According to a 2024 study by the US Bureau of Labor Statistics, 41% of companies that offer a 401(k) plan provide employer matching contributions up to 6% of employees’ salaries. Only 10% of companies offer more than 6%, with the top employers offering up to 25%.

Tax advantages

Contributions to Traditional 401(k) plans are tax-deferred, meaning your employees do not pay income tax on their contributions or earnings until they withdraw the funds in retirement. Roth 401(k) contributions, on the other hand, are made after-tax, but withdrawals—including investment earning tax-free in retirement.

Investment options

401(k) plans offer a variety of investment choices, such as mutual funds, target-date funds, bonds, and stocks. Employees can choose their preferred investments based on their risk tolerance and financial goals.

Portability

If your employee leaves your business, they can often roll their 401(k) funds into a new employer’s plan or an Individual Retirement Account (IRA).

Contribution limits

For 2025, the contribution limit is $23,500 for individuals under age 50. Those aged 50 and older can contribute an additional $7,500 in catch-up contributions.

The benefits of offering a 401(k) plan for you as an employer

You attract top talent

In today’s competitive job market, a robust benefits package that includes a 401(k) can set you apart. Talented candidates often prioritize employers who demonstrate a commitment to their financial future.

An Accenture study found that 68% of workers said a retirement plan was a critical factor in deciding whether or not to accept a job, while 62% said a plan was a critical factor in staying with a job.

You retain your best employees

A 401(k) plan with attractive features, such as employer matching, can be a useful tool for improving employee retention. Employees are more likely to stay with a company that invests in their long-term well-being.

Tax incentives

You can deduct matching contributions as a business expense, reducing your business’ overall tax liability. Additionally, if you start a new 401(k) your business may qualify for tax credits of up to $5,000, for three years to offset setup and administrative costs.

Enhanced company reputation

A well-designed retirement plan reflects positively on your brand. It shows that you value your employees, which can improve morale and enhance your business’ reputation.

The benefits of a 401(k) plan for employees

Tax advantages

As detailed in our Understanding the Basics section, the tax benefits of a 401(k) plan are a primary draw for employees.

Employer matching contributions

If a business offers a match of employee contributions, this further bolsters an employee's retirement savings.

Compound growth

A 401(k) plan’s tax-deferred growth means that contributions and investment earnings can grow without being diminished by taxes. Over time, compounding can significantly boost retirement savings.

Automatic savings

401(k) contributions are deducted directly from an employee’s paycheck, making saving for their retirement effortless. This "out of sight, out of mind" approach helps your employees save consistently.

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How you can implement a 401(k) Plan

Knowing how a 401(k) plan works is one thing. Implementing it is quite another. Making your 401(k) plan work for both employer and employee alike can be daunting. Here's how to get started.

Choose the right plan type

You can choose from different 401(k) plans, as detailed earlier in this guide.

Select a plan provider

Partnering with a reputable financial institution or plan administrator is essential. Providers manage plan setup, compliance and investment options on your behalf.

Determine employer contributions

This is a key decision for you to make.  You will need to take into account a number of factors; including affordability, the importance of the 401(k) as a recruitment and retention strategy, and the type of 401(k) you have will dictate the contribution rules you must comply with

Communicate with employees

It is important to ensure your employees are educated about the plan’s features and benefits. Clear communication ensures higher participation rates.

Monitor and review

By regularly reviewing the plan, you can ensure it meets employees' needs, your business strategy and complies with regulatory requirements.

The future of 401(k) plans

There are changes in the retirement landscape in the USA from 1 January 2025. The SECURE Act 2.0 is introducing automatic enrollment of eligible employees for all new 401(k)s set-up from 29 December 2022.  

These changes will further bolster the popularity of 401(k) plans, and will have a positive impact on the retirement savings of the nation.  If you’d like to learn more, we’ve also prepared some resources on understanding auto-enrolment in the USA for 401(k) plans.

A 401(k) plan is a powerful tool for building retirement savings.  A well-designed 401(k) plan can offer significant benefits for you and your employees.

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