401K Planning 101: Flexible Contribution Amounts

Saving for retirement is of utmost importance for anyone looking for financial stability and independence in the future. Still, many people put off taking action until it’s too late, leading…

April 26, 2023

Written by Justin Sloan

Saving for retirement is of utmost importance for anyone looking for financial stability and independence in the future. Still, many people put off taking action until it’s too late, leading to a retirement filled with stress and uncertainty. If you’re a business owner, offering a retirement savings plan is one of the best ways to help your employees prepare for their golden years. Not only will it encourage your employees to save more, but you can also benefit from certain tax deductions and other incentives. Different retirement plans are available, but the most common is the 401K.

Perhaps you’ve heard of a 401K before, but you may not know much about them. Understanding the basics is crucial before deciding if a 401K is right for your business. Otherwise, you may be unable to take full advantage of your plan’s features, like flexible contribution amounts. This blog post will discuss everything you need about business 401K planning and flexible contribution amounts. We’ll explain these plans, the types of investments you can make, how to determine the right amount to contribute, and more. By the end of this post, you’ll be well-informed and ready to make intelligent decisions.

What are Business 401K Plans, and How Do They Work?

A 401K is one of many retirement savings plans employers can offer. The “401K” in the name comes from an Internal Revenue Code section outlining how these plans work. They’re an alternative to pensions, where employers commit to providing a predetermined amount to retired employees for life. In contrast, 401Ks allow employees to contribute money to a retirement fund. These plans are also portable, meaning employees can take their savings with them if they leave the company. For these and other reasons, 401Ks have become the preferred retirement plan.

Employees can contribute to 401Ks through payroll deductions and have the option to increase or decrease the amount at any time. The employer may also match employee contributions up to certain limits. These funds go into different investments, like stocks or bonds, intending to grow the account over time. When employees reach retirement age, they can withdraw money from their 401Ks to maintain their lifestyles. Depending on the type of plan, withdrawals may be taxed as ordinary income. There may also be a 10 percent penalty if the team member withdraws funds before age 59 ½ unless they qualify for an exception.

Types of 401K Plans

You can choose from various 401K plans, depending on the size and needs of your business. The most common types are Traditional, Roth, Safe Harbor, and SIMPLE 401Ks.

  • Traditional 401Ks are the most popular option, allowing employees to make tax-deferred contributions. That means their contributions aren’t subject to taxes until they withdraw them, usually at retirement age. Employers may also be able to deduct employee contributions from their taxes.
  • Roth 401Ks are similar to Traditional 401Ks but differ in terms of taxation. Contributions to these plans come from after-tax income and grow tax-free. Therefore, all withdrawals, including earnings, will be free of taxes if the account has been open for five years or more.
  • In a Safe Harbor 401K, employers commit to making matching or non-elective contributions. The IRS then waives the annual nondiscrimination testing, which measures the plan’s fairness and whether highly compensated employees are receiving too much. Employer contributions are also fully-vested immediately, meaning employees can take them with them when they leave the job.
  • Simple 401Ks are available for small businesses with fewer than 100 employees who receive over $5000 a year. They aim to provide an effective, cost-efficient retirement plan for small businesses that can’t afford to set up more complex options. Like Safe Harbor 401Ks, employers must commit to making full-vested contributions.

Types of Investments Employees Can Make through a 401K Plan

Team members who want to invest in a 401K have various options. Some employers offer predetermined products like mutual funds, while others give employees the freedom to choose for themselves. Typical investments include stocks, bonds, money market accounts, exchange-traded funds (ETFs), and certificates of deposit (CDs). Depending on your plan type, investments may also be subject to specific regulations. For instance, the IRS limits how much of the plan’s assets can be invested in employer stock.

  • Bonds: Bonds are investments where you loan money to a company or the government. They then make interest payments until they repay the total amount, at which point the bond matures.
  • Stocks: Stocks are shares of ownership in a company. When employers purchase stocks, they become part-owners of the business and can receive dividends based on the organization’s profitability.
  • Mutual Funds: Mutual funds are professionally managed collections of stocks and bonds that can give exposure to more markets than buying individual securities would allow.
  • Money Market Accounts: Money market accounts are like high-interest savings accounts with low risk but limited liquidity. You usually need to maintain a certain balance in these accounts, so they’re not ideal for short-term investing.
  • Exchange-Traded Funds (ETFs): ETFs also invest in different stocks and bonds, but their structure differs slightly from mutual funds. These investments have become popular recently because they’re more tax efficient and don’t require a minimum investment amount.
  • Certificates Of Deposit (CDs): CDs are similar to high-interest savings accounts but usually have higher interest rates than money market accounts. They also come with a fixed maturity date and penalty fees if you withdraw your funds before then.

What do Flexible Contribution Amounts Mean?

Flexible contribution amounts allow employers and employees to adjust the amount of money they contribute to their 401K accounts each year. Employers can tailor their contributions to match budget or business needs changes. At the same time, team members can increase or decrease theirs to reflect changes in their financial goals. They can do this yearly or quarterly, depending on their plan’s rules. Ultimately, flexible contributions give employers and employees more control over the money they’re investing in their 401K accounts.

The annual contribution limit for a 401K plan changes yearly, and the IRS sets the limit. In 2023, employees are allowed to contribute $22,500, but those over 50 are eligible for an additional “catch-up” contribution of $7,500. Total contribution limits for employers and employees combined are $66,000 or 100 percent of compensation (whichever is less). If you decide to make flexible contributions, you’ll need to keep track of how much you’ve contributed each quarter or year to stay within this limit.

Help your Team Members Determine the Right Amount to Contribute

Your employees should consider their short- and long-term goals when determining how much to contribute to a 401K plan. Suppose they have short-term financial goals, such as buying a house or starting a business. In that case, investing in other types of accounts that offer more liquidity might be more beneficial. On the other hand, if they mainly want to save for retirement, contributing regularly and consistently will help maximize the growth potential of their investments. They can use their 401K earnings to leave a legacy for their family, pay for long-term care, or whatever else they’d like.

When figuring out how much to contribute, you should also encourage your team members to consider their current income level and expected raises over time. It would be best if they adjusted their contributions accordingly as their salary increased. This way, you can ensure they’re making the most of their 401K contributions without overextending themselves. Regardless of their decision, remember that flexible contributions give you and your employees more control over your retirement plans. Therefore, you shouldn’t hesitate to make adjustments as the situation changes. 

Benefits of Making Flexible Contributions

Making flexible contributions to a 401K plan can lead to several benefits for employers and employees, including the following:

More Control Over Investments 

As we mentioned, the main benefit of making flexible contributions is that employers and employees can better manage their retirement investments. You won’t be tied to a fixed contribution amount, which could help you adjust to an ever-changing financial landscape.

Investment Growth

Since you have more control over your contribution amounts, you can invest more strategically. As a result, it’s easier to maximize the growth potential of your investments by choosing appropriate asset classes and regularly rebalancing.

Greater Tax Savings

Different 401K plans have different contribution limits and tax advantages. By making flexible contributions, you and your team members can maximize these tax benefits while staying within the annual contribution limits.

Easier Long-Term Planning

Regularly contributing to a 401K plan provides confidence for retirement planning. You’ll be able to adjust your risk level as needed without liquidating your account. Plus, the compounding of your investments means you’ll likely see greater returns over time.

Set Up Your 401K Plan with the Help of Tax Professionals

As you can see, making flexible contributions to a 401K plan can be an intelligent way to invest for retirement. However, you must understand a 401K plan’s tax implications before you start. At Nesso Tax, we’re a team of professional tax advisors in Milldale, CT, that can assist you in navigating the complexities of a 401K plan. We’ll guarantee your decisions are sound and compliant with IRS regulations. Our advisors are committed to helping you pursue your financial goals and enjoy a secure retirement. Contact the Nesso Group today to learn more about our tax services.

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