Class is In Session: A Primer on 401(k) Plans

Offering a 401(k) continues to be a popular way to help employees build up their nest eggs. The most common version is the traditional one, which allows employees to save for retirement on a pretax basis and the employer to match all or a percentage of employee contributions. But there are other 401(k) options you might want to consider as well.

How it works

With a traditional 401(k), plan assets grow tax-deferred, but withdrawals are taxed. In 2012, employees can defer up to $17,000 through salary reductions. (Employees age 50 and over by year end can make an additional contribution of $5,500.) The 2012 combined employer-employee contribution limit is the lesser of 100% of compensation or $50,000 — $55,500 for those age 50 or over.

One detriment to a traditional 401(k) plan is that it’s subject to rigorous testing requirements to make sure the plan is offered equitably to employees.

Finding safe harbor

Federal rules require a traditional 401(k) plan to benefit rank-and-file workers and highly compensated employees (HCEs) proportionally. This means that, if rank-and-file workers don’t contribute enough, HCEs may not be able to contribute the maximum — and may get a portion of their contribution returned to them.

If your company can’t easily meet these rules, consider a Safe Harbor 401(k). Under this plan, employers must make certain contributions, but owners and HCEs can maximize their contributions regardless of the amount rank-and-file workers contribute.

To qualify for the safe harbor election, the employer needs to either:

• Contribute 3% of compensation for  all  eligible employees, even those who don’t make their own contributions, or

• Match 100% of the first 3% of worker deferrals and 50% of the next 2% of deferrals.

The required contributions can make a Safe Harbor 401(k) a substantial investment for your company. Plus, employer safe harbor contributions vest immediately, which could be costly if your staff turns over quickly.

Keeping it simple

If your business has 100 or fewer employees, consider a Savings Incentive Match Plan for Employees (SIMPLE) 401(k). Like a Safe Harbor 401(k), the employer must make fully vested contributions, and there’s also no rigorous testing (though the IRS does require an annual filing).

But under a SIMPLE 401(k), eligible participants can defer a smaller amount: only up to $11,500 in 2012 ($14,000 for those 50 and over). As the employer, you generally must match contributions up to 3% of employees’ pay or make nonelective contributions of 2% of all employees’ pay regardless of whether they contribute. So required employer contributions are a little lower than with a Safe Harbor 401(k).

Why you may want a Roth

A Roth 401(k) allows employees to contribute after-tax dollars but take  tax-free  withdrawals (subject to certain limitations).

Employer contributions, however, can go into only traditional 401(k) accounts. And many employees will still want to use the traditional plan for their own contributions to take advantage of the current tax savings.

Generally, employees who expect their marginal tax rates to remain almost as high or be higher in retirement are better off with a Roth 401(k). Conversely, those who expect their tax rates to decrease significantly will likely do better with a traditional plan.

Some employees may like having the opportunity to split their contributions between the two types of accounts. And employees whose incomes are too high for them to be eligible to make Roth IRA contributions may especially appreciate the Roth 401(k) option, because no such limits apply to the Roth 401(k).

In 2012, participants can make combined contributions to traditional and Roth 401(k) accounts of up to $17,000 ($22,500 for those age 50 or over).

Closing thoughts

A 401(k) plan is still one of the best options for employees who want to diligently contribute to a retirement plan. So make sure you continue contributions to your employees’ 401(k) or Roth 401(k) plans. Class is over.