401(k) Plan

What Is a 401(k)?

A 401(k) plan creates an opportunity for contributions to grow until retirement.    

The term “401(k)” comes from Section 401(k) of the U.S. Internal Revenue Code. This section established the rules for employer-sponsored retirement plans that let employees set aside part of their earnings for retirement with valuable tax advantages.

Small businesses may include a 401(k) plan in their benefits package to help attract and retain talent. They also have the option to match a portion of employee contributions or make a profit-sharing contribution. The Bureau of Labor Statistics reports that 52% of small businesses now offer a 401(k) plan to their employees.¹

Gross Pay Formula & Calculation

Employer contributions may use various formulas to calculate the match, often based on a percentage of the employee's salary and contributions.  

Specific tax benefits depend on the type of 401(k) retirement plan you choose.  

There are two main types of 401(k) participant contribution options: traditional and Roth. The key difference is when individuals pay taxes.  

Each option offers unique benefits and tax implications.  

It’s important to understand the differences. It’s best to consult with a financial professional to make an informed decision about the best options for your needs. You can get a basic understanding of the differences, formula, and calculations by using our free Roth vs Traditional 401(k) calculator.

Employee Contributions

With traditional 401(k) contributions, the amount is deducted from an employee’s paycheck before income taxes are applied. This can reduce taxable income for the year. The 401(k) account balance grows tax-deferred until funds are withdrawn in retirement.

A Roth 401(k) works the opposite. Individuals make contributions after income taxes are deducted, so there’s no immediate tax break. However, withdrawals in retirement, including both contributions and earnings, can be taken tax-free, provided certain IRS conditions are met.

Employer Matching Contributions

One of the biggest advantages of a 401(k) is that businesses can elect to contribute to helping employees save for retirement. For the employees, this additional compensation is essentially "free money." Getting the full employer match can significantly enhance total retirement savings over time.

As a small business owner, you can decide how matching works for your team. Many employers match employee contributions up to a certain percentage of pay, such as dollar-for-dollar on the first 3% or 50 cents for every dollar contributed up to 6%.  

This flexibility can allow you to design a plan that fits your budget while still offering a meaningful incentive for employees to save for their future. Businesses can also choose to provide a profit-sharing contribution, where they contribute a discretionary amount, usually based on profits.

Investment Options

Small business owners can also decide how the employer-sponsored 401(k) plans will be invested and how those investments will be managed. You can either give employees the ability to choose from a list of investment options or manage those investments on their behalf.

If you opt to allow employees to direct their own investments, you’ll need to select what kinds of funds to make available, typically a mix of mutual funds.  

Many business owners work with a financial advisor or 3(38) investment manager to identify and monitor these options, so they continue to serve the best interests of participants.

To see how different investment choices could impact long-term savings, check out our free 401(k) calculator.

401(k) Benefits Explained

Here’s a closer look at some of the key benefits 401(k) offer employees and employers.

Tax Advantages

One of the biggest reasons employees and employers value a 401(k) plan is the potential for tax savings.

With traditional 401(k) deferrals, employee contributions are made before taxes are taken out of their paychecks. This can lower their taxable income for the year and allow the money in the account to grow tax-deferred, meaning taxes aren’t due until the funds are withdrawn in retirement.

Employers may also benefit from offering a 401(k), since contributions to employee accounts may be deducted as a business expense.

Long-Term Savings Power

Offering a 401(k) plan gives employees the chance to grow their savings steadily over time through compounding. This means the returns their investments earn are reinvested, allowing them to generate additional earnings of their own.  

Employer Contributions

Employers may choose to contribute to their employees’ 401(k) accounts as part of their benefits package. This can take the form of a matching program, where the employer contributes a certain amount based on what the employee saves. Matching not only helps employees grow their retirement savings faster but also encourages participation in the plan.

Another key feature of employer contributions is the vesting schedule. Vesting determines when the employer’s contributions fully belong to the employee. Some plans offer immediate vesting, while others use a gradual schedule, giving employees ownership of a larger portion of those monies over time.

Together, matching and vesting programs can make a 401(k) plan more appealing to employees and serve as a valuable tool for attracting and retaining talent.

Accessibility & Automatic Savings

Another advantage of the 401(k) is its automatic enrollment feature. Contributions are deducted directly from each paycheck, making it easy for employees to build retirement savings consistently and without extra effort.

401(k) Rules You Should Know

While 401(k) plans offer valuable tax advantages and long-term growth potential, they also come with specific rules set by the IRS.  

Contribution Limits (Annual)

The IRS establishes annual limits on how much individuals can contribute to their 401(k) plans. For 2025, employees can contribute up to $23,500 to their 401(k) plan, whether it’s traditional or Roth. Those age 50 and older can make an additional $7,500 catch-up contribution to help boost their retirement savings. People who are aged 60 to 63 can make an additional $11,250 super catch up contribution in 2025.

Withdrawal Rules

There are clear IRS guidelines around when 401(k) funds can be withdrawn. In most cases, employees must wait until age 59½ to take distributions without penalty. Early withdrawals generally trigger a 10% penalty, along with regular income taxes, though exceptions may apply for situations such as financial hardship or separation from an employer after age 55.

Once employees reach a certain age, withdrawals become mandatory. Starting at age 73, the IRS requires minimum distributions (RMDs) each year. Missing an RMD can lead to additional penalties, so it’s important for participants to stay informed and plan.

Vesting Schedules

An employee's own contributions to their 401(k) plan are always 100% vested, or owned, by the employee.  

Vesting schedules apply only to employer contributions, such as matching or profit-sharing amounts, and must follow IRS minimum requirements.  

While the specific schedule can vary by plan, most use either a graded vesting schedule, where employees become fully vested after up to six years of service, or a cliff vesting schedule, which provides 100% vesting after three years. Regardless of the method, IRS rules require that all employer contributions become fully vested once an employee reaches the plan’s normal retirement age or if the plan is terminated.  

Loan & Hardship Withdrawals

Some 401(k) plans allow employees to borrow or withdraw money from their retirement account before reaching retirement age, but it’s important to understand the rules and potential drawbacks.

With a 401(k) loan, employees can borrow against their savings and repay the amount (plus interest) over time, typically through payroll deductions. While this can provide short-term financial relief, borrowing reduces the account’s growth potential, and failure to repay the loan on schedule can turn it into a taxable withdrawal with penalties.

Hardship withdrawals are another option in specific circumstances, such as covering certain medical expenses, preventing foreclosure, or paying tuition. However, these withdrawals are generally subject to income taxes and may also incur a 10% early withdrawal penalty unless the situation specifically qualifies for an exemption.

Employers should clearly outline these provisions in their plan documents, so employees understand when and how loans or hardship withdrawals are permitted and what financial risks they carry.

401(k) Examples (How It Looks in Real Life)

Everyone’s retirement journey looks different, depending on income, contribution levels, market performance, and investment choices. The following examples of how 401(k) plans could work are for general educational purposes only and not intended as financial advice. Actual results will vary, and it’s always best to consult a qualified financial professional before making investment decisions.

Example 1: Employee saving $200/month with employer match

Imagine an employee who contributes $200 per month to a traditional 401(k), and their employer matches 50% of that amount. That’s an additional $100 each month, with a total of $300 going into the account.

If those contributions continued steadily for 20 years and the account earned an average annual return of around 6%, the balance could grow to over $130,000.  

Remember, this is only a simplified example; the actual outcome would depend on market performance, investment choices, and plan fees.

Example 2: Comparing Roth vs. Traditional 401(k) over 20 years

Let’s say two employees each contribute $300 per month to their 401(k) plans for 20 years, and both accounts earn an average annual return of about 6%. One employee contributed through a traditional 401(k), the other to a Roth 401(k).  

Over that time, each account could grow to over $130,000, assuming consistent contributions and stable market performance.  

The difference between the two is when taxes are paid.  

With traditional 401(k) deferrals, contributions are made before income taxes are applied, which lowers taxable income in the year of contribution, but taxes will be due when the money is withdrawn in retirement.  

A Roth 401(k) deferral works in reverse: contributions are made after taxes, but qualified withdrawals in retirement are generally tax-free.

Neither option is automatically better. It depends on each person’s income, tax situation, and retirement goals. A financial professional can help determine which type of plan makes the most sense based on individual circumstances.

Example 3: Early withdrawal penalty scenario

Consider an employee who withdraws $10,000 from their traditional 401(k) before reaching age 59½. Because early withdrawals are generally subject to both income tax and a 10% early withdrawal penalty, the total amount received would be reduced significantly.

For instance, depending on the employee’s tax bracket, they might owe about $1,000 in penalties plus $1,500 to $2,200 in federal income taxes. That means the $10,000 withdrawal could leave them with only $6,800 to $7,500 after taxes and penalties.

This broad example illustrates why 401(k) funds are best viewed as long-term retirement savings. While exceptions exist for certain hardships or qualifying events, withdrawing early can quickly erode the value of a person’s savings and should be considered only after consulting a financial or tax professional.

401(k) vs. Other Retirement Accounts

A 401(k) is just one of several ways to save for the future. Each type of plan has its own structure, tax treatment, and level of employer involvement. It’s best to consult with a financial professional to determine the best option for you.  

401(k) vs. IRA

A 401(k) is an employer-sponsored savings plan that allows employees to contribute through payroll deductions, often with the added benefit of employer matching contributions. By contrast, an Individual Retirement Account (IRA) is opened by an individual, not an employer, and has lower annual contribution limits. IRAs offer similar tax advantages but may provide more flexibility in investment choices.

401(k) vs. Pension

A 401(k) is a defined-contribution plan, meaning the employee and employer contribute to an individual account, and the eventual balance depends on total contributions and investment performance. A pension, on the other hand, is a defined-benefit plan that guarantees a specific payment in retirement, typically funded and managed by the employer. While pensions are less common today, both pensions and 401(k) plans can play valuable roles in retirement planning.

401(k) vs. Savings Account

A 401(k) is designed for long-term retirement investing, with potential tax advantages and restrictions on early withdrawals. A savings account provides easy access to funds and minimal risk but generally earns less interest and doesn’t offer the same tax benefits. For many people, a traditional savings account serves as a short-term or emergency fund, while a 401(k) is used to build long-term financial security.

Common Misconceptions About 401(k)s

Despite being one of the most popular retirement savings tools, the 401(k) is often misunderstood. Let’s clear up a few common misconceptions that can prevent your employees from seeing its full potential.

• "I can’t touch the money until retirement." It’s true that 401(k)s are designed for long-term savings, but that doesn’t mean funds are completely off-limits. Some plans allow loans or hardship withdrawals in specific circumstances, such as medical emergencies or avoiding foreclosure. While these options should be used sparingly, they do provide limited flexibility when truly needed.

• "The employer match isn’t worth much." Even a modest employer match can make a meaningful difference over time. For example, an employee contributing $200 per month with a 50% employer match receives an extra $100 each month, money that compounds and grows alongside the employee's contributions. Over many years, that "free money" can translate into thousands of additional dollars in retirement savings.

• "I don’t make enough to contribute." It’s easy for employees to assume they need a high income to save for retirement, but small, consistent contributions can add up. Even setting aside 1% or 2% of each paycheck can create a foundation for long-term growth, especially with compounding and potential employer matching.  

A financial professional can help address employee questions and concerns about 401(k) retirement plans.  

Key Takeaways

A 401(k) is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their paycheck toward future financial security.  

With potential tax advantages, automatic payroll deductions, and the option for employer matching, it can be a practical way to encourage consistent, long-term saving.

While 401(k) plans come with specific rules, from contribution limits to withdrawal guidelines, they also offer flexibility for both employers and employees. For small businesses, offering a 401(k) can help attract and retain team members while providing potential tax benefits for the company.

SurePayroll offers solutions built with small businesses in mind. Through Sure401k®, employers can easily establish a retirement plan that fits their company’s size, goals, and budget, whether for themselves, their employees, or both.  

Call us at 866-497-2028 or fill out the contact form on our website to connect with a SurePayroll representative.

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¹_{U.S. Bureau of Labor Statistics, March 2023}