The Ultimate Guide to Starting A 401K (For Yourself Or Your Business)
Brief Overview
If you’re asking yourself “how do I start a 401(k)?” you’re certainly not alone but we’re here to give you actionable steps to accomplish that goal.
To open a 401(k) for yourself contact your employer and ask if you are eligible for participation, ask if you have been automatically enrolled or if you must do so manually, choose how much money you wish to contribute, and finally choose investment options based on your contributions and risk tolerance.
To make 401k plans for your employees, choose the best type of 401(k) for your business, create a plan document that adheres the standards set by the IRS, set up a trust that will hold the plan’s assets, create a record keeping system, and communicate the details of your plan to current and prospective eligible employees.
What is a 401(k)
A 401(k) is a retirement investment account that is sponsored by an employer. Its primary benefit is that employees are able to save a portion of their paycheck before taxes are taken out and many employers offer a contribution match. This means that you are able to decrease your tax burden while simultaneously increasing the amount deposited into your account thanks to an employer match.
Wondering what happens to the money once its placed in a 401(k)? A 401(k) operates on different fundamentals than a typical savings account does. It can be a better option than simply opening a savings account at a local bank because a 401(k) puts your money to work.
What does “putting your money to work” mean? The funds that you deposit in this retirement savings account are placed into investments - often mutual funds - which provides you with the potential to grow your pre-tax money with a greater rate of return than you would be able to with a traditional savings account. You are able to control the way in which your money is invested by varying the ratio of stocks to bonds, changing level of diversification in your investment portfolio, and choosing which type of companies you wish to invest in depending on the specific parameters set by your employer.
Why you should start a 401(k)
While there are several investment options that you can use to save for retirement, 401(k)s offer some unique benefits.
How a 401(k) benefits employees:
Potential higher rate of return:
According to the Federal Deposit Insurance Corporation (FDIC), the average rate of return on savings accounts is just 0.10% annually in 2019. Seeing as though that return is dwarfed by the Federal Reserve’s 2% target inflation rate, you would actually be losing money every year that you left it there.
Inflation is the price of goods and services increasing over time. For example, think about how much you paid to eat out at a restaurant 15 years ago versus today. If prices are increasing, you want the value of your money to also increase over time. Hence why growing above the 2% inflation rate is desirable.
A 401(k), on the other hand, offers a long-term savings solution that can experience unadjusted annual returns between 5 and 12 percent. When you take inflation into account you could see your money grow from between 3 to 10 percent in a year. We are not guaranteeing these returns as they will be determined by the management of your particular portfolio and the state of the economy amongst several other factors.
Even with no promises of making extraordinary returns, which would you rather do: save your money for retirement with a chance to grow it along the way or dump your nest egg into a savings account at your local bank and be guaranteed to lose money in the long-run?
Tax-free Investment Growth:
Investing your money before taxes are taken out of it is an excellent perk of a 401k. Letting your money grow pre-tax provides you with the opportunity to decrease your tax burden in retirement. This means that you’re effectively exchanging the payment of taxes today in return for paying them at a later date when your tax bill is likely to be lower. Investing is all about the long game in many instances and this is just one example of how investing in a 401(k) is a long-term financial strategy that can prove to be a powerful money-saving tool.
Matching employer contributions:
The pièce de résistance, if you will, of 401(k) plans is their potential to include matching employer contributions. This is the primary selling point of a 401(k) and what gives it a leg up on solo-retirement savings accounts.
For instance, if you earn $100K / year and your employer matches up to 5% of your salary, we’d suggest adding at least $5K into your 401K. Why? Because your employer will give you an additional $5K just because you’re participating in the 401k plan. This means in one year you already have $10K in your account and that’s without any market growth!
Rollover and transfer options:
Yet another benefit of utilizing a 401(k) is that you can roll your money over in various ways so that you never have to worry about your money being stuck in one place.
You can leave your money in a previous employer’s 401(k) plan if they allow it should you change jobs. Doing so will give you valuable time to evaluate your next investment choices. If you find that your new employer’s terms (investment options, fees, and other features) are more favorable to those of your old plan, you can roll your funds over. By doing so you will be able to have all of your funds in one place where they can be easily managed. This is the best of both worlds because you have the choice of where your money goes. The added peace of mind that comes along with knowing that your funds can be moved even if you should leave your employer is invaluable.
What if you leave your job and your new employer does not have a 401K or you decide to work for yourself? Well 401(k)s can be adapted to this life change as well.
Your account can be rolled over into the various forms of an Individual Retirement Account (IRA). These tax-deferred retirement accounts provide you with the opportunity for pre-tax investment growth without the need for employer sponsorship.
Frankly, if you leave your job and want more investment options, you can roll your 401K into an IRA regardless of your next career move.
As a final option, should your money be burning holes in your pockets, is a cash distribution. This means withdrawing your money from your 401(k) entirely. Taking this route is the least advised of the three because while it may seem to have short-term benefits, you may face penalties that could be detrimental to your long-term strategy.
You may be subject to a mandatory 20% federal withholding tax rate, not to mention 401(k)s carry early withdrawal penalties of 10% (if you withdrawal the money before age 59 ½ ) that you will also be on the hook for. Remember those deferred taxes we mentioned? You’ll also have to pay those now that you’ve taken money out of the 401(k).
It is always wise to consult with a professional before you take action on rollovers. It could save you hundreds or even thousands of dollars in tax and penalty-based fees that you didn’t see coming depending on the size of your portfolio.
How a 401(k) benefits employers:
Attract and retain top talent:
40% of employees working for small businesses say that they would leave their current company for one that offers a 401K.
Not only can 401(k)s lure great employees away from other companies, but they can also lure them directly to you! Providing employment benefits to employees is much more than a gimmick, it is a benchmark that employees gravitate to and take action on. Taking advantage of this fact by implementing your own 401(k) program can have a positive impact on the ongoing development of your team.
Tax Benefits:
By now you have probably heard about the tax benefits of this form of retirement savings account but you may not know that businesses can reap tax rewards by sponsoring 401(k) plans. According to the IRS the there are two advantages to utilizing these plans in your business.
The first advantage is that employers are allowed to deduct their contributions to 401(k)s on their tax returns. This is allowed as long as contributions do not exceed set limits which can be found in section 404 of the Internal Revenue Code or on page 15 of the IRS’s Publication 560 (Retirement Plans for Small Business).
Less risky alternative to pensions:
If you’re considering whether you should offer employees a pension or a 401(k), you may want to consider the benefits of sponsoring a 401(k). With a pension a majority of the risk falls on the provider because they are offering a set amount of retirement income without involving the employee in the management of the account.
In the case of a 401(k), employees are responsible for choosing how their money is invested and result of those efforts determine the longevity of their funds and the amount of retirement income that they can generate. This is why pensions are known as defined benefit plans and 401(k)s fall into the bucket of defined contribution plans.
As a business owner, you understand the importance of mitigating risk at every turn and a 401(k) does just that. With a 401(k) you give your employees the reigns and allow them to determine their own outcomes. This can relieve the stress that comes along with feeling the need to be overly involved with keeping a pension plan afloat. Instead, use that energy to focus on building your business.
Starting one for yourself
(Step 1) Reach out to your employer
Don’t be afraid to approach your employer about employment benefits! If you consult your employee handbook (on the slim chance that you happen to have one lying around) and don’t see any information pertaining to employee benefits, you should speak to your manager or a senior member of your company. They will be able to either give you information on your options, connect you with someone that can or discuss their own benefits with you. Talking about finances in the workplace is an excellent way to find out if you’re missing out on benefits or if you’re being underpaid.
(Step 2) Ask your employer if you’re eligible
Eligibility for your employers 401(k) is determined by the IRS’s plan qualification requirements in addition to any employer specified criteria such as length of employment. Ensure that you receive all of the eligibility rules from your employer and then review them to determine if you are eligible rather than allowing them to decide this for you. They may make a mistake due to inaccurate information and this could cost you money in the long run.
When in doubt, contact a financial professional who will be able to definitively discern your eligibility based on which type of 401(k) your employer offers.
(Step 3) Decide how much to contribute
Ok, so now you’ve enrolled in your 401(k) but now what? This is the time to break out your financial plan and decide on how much you want to contribute to your new account. Remember that there are limits placed on how much you can contribute.
Employees can contribute $19,000 annually in 2019
Contributors over 50 can make an additional catch-up contribution of $6,000 annually
Seriously consider contributing the maximum amount as you will want to take advantage of your employers contribution match. The limit for combined contributions of both the employee and employer to a 401(k) plan in 2019 is 100% of the employee’s salary or $56,000 (whichever is less).
(Step 4) Choose the right investments
It is impossible for us to tell you exactly which investments are best because that depends entirely on a bevy of factors including your risk tolerance, the options given by your employer, your personal investment interests and your desired outcomes. There is not a one size fits all answer when it comes to choosing good investments which is why it is recommended that you speak to someone who is knowledgeable in the field of retirement savings accounts.
A large part of your investment strategy comes down to your asset allocation. Choosing whether to put your money in less risky bonds or higher risk stocks will greatly affect how your portfolio performs. With bonds you are able to exchange lower risk for lower return or by placing a larger portion of your funds into stocks you exchange greater volatility for a potentially higher return.
This is just a simplified example of how you can manipulate your investments to fit your personal taste. By meeting with a financial advisor you will be able to uncover multiple ways that you can tailor your portfolio to your specific needs rather than just throwing money at an account and praying that everything works out.
What if your employer doesn't offer a 401(k)?
Consider an Individual Retirement Account
IRAs are an option for people who are self-employed but they can be opened by anyone who has income from a job that is claimed for tax purposes.
While you may be missing out on the employer match offered by a 401(k), you will still receive tax benefits albeit slightly different ones.
With a Traditional IRA, your contributions will be able to grow tax-free. Traditional IRAs provide a tax deduction based on the tax year that a contribution was made in. For information on contribution limits and deductible contribution qualifications, visit the IRS’s guide.
Roth IRAs allow individuals to pay taxes on their investments when they contribute. In retirement, their withdrawals can be taken out tax-free. Unlike Traditional IRAs, owners of Roth IRAs are not able to deduct their contributions and do not have to take required minimum distributions.
There are some additional benefits of a ROTH, such as being able to access any of the money you add (sans growth) at any time, so long as the account has been open for at least 5 years. For a comparison between Traditional and Roth IRAs, visit the IRS’s guide.
Consider a Solo 401(k)
Solo 401(k)s go by many names such as a Self-Employed 401(k) or an Individual 401(k) but the IRS recognizes them as One-Participant 401(k) plans. In this plan, the employee and the employer may be the same person but they may contribute to the account separately contribute separately.
This means that as a business owner you can contribute to your 401(k) as an employee would while matching those contributions as an employer would. Talk about wearing multiple hats in business!
The limits on these types of accounts are the same as a regular 401(k) plan. In fact, the IRS states that a Solo 401(k) isn’t a different plan at all. It is simply a traditional 401(k)’s way of covering a business owner with no employees, or that person and his or her spouse.
They also carry the same rules and requirements so be sure to reference the benefits section discussed earlier in this article if you think that this applies to you.
Consider a Taxable Brokerage Account
There are a few reasons why a standard taxable brokerage account could be a good option for you, whether you already have a 401(k) or not. These accounts are great supplements to your existing retirement accounts and here’s why:
You can access your money at any time
You can contribute any amount of funds
Restrictions on your investment choices are drastically reduced
In exchange for paying taxes on the money that you put into the account, you are gaining quite a bit of freedom and flexibility in terms of what you do with that money.
If you’re planning on retiring early a 401(k) may not work for you as it will cost you to withdraw it before the age of 59 ½. If you’ve reached your contribution limit on your 401(k) or IRA but still want to invest then a taxable brokerage account has you covered.
Maybe you’re looking to take on a high risk investment (like buying stock in a company that you think will become the Google (GOOGL) of the pancake industry for example) with some extra money that you’ve managed to save. If so, your brokerage account is a great place to do it.
Starting a 401(k) for a business
(Step 1) Choosing the right type of 401(k)
Under the umbrella of a 401(k), there are several plans to choose from. Choosing which one best suits your needs based on your company and the needs of your employees is the first step in getting started.
Traditional 401(k) plans
Safe harbor 401(k) plans
SIMPLE 401(k) plans
(Step 2) Create a plan document
This document will function as the guidelines for your 401(k) plans. It will list the contribution amounts and employee eligibility rules. Because this document is legally binding, you will want to consult a professional when writing it.
Getting a professional to write the entire document is a great option as it must be very detail oriented. The plan document must abide by the guidelines set forth by the IRS. If you choose to have an institution manage your 401(k) for you then they will likely create the plan on your behalf.
(Step 3) Set up a trust
By setting up a trust, you are effectively guaranteeing that the contributed funds are only to be used by participants and their beneficiaries. 401(k) funds are not to be used as a business’ personal piggy bank and a trust ensures that this does not happen.
Selecting a trustee who is to manage contributions, distributions and investments is a part of the set-up process.
(Step 4) Create a record keeping system
Keeping track of your 401(k) plans is extremely important which is why you must have a record keeping system in place. Having a financial institution or wealth manager handle your records is your safest bet as they have the tools and resources to do the job effectively.
Annual reports are required on your plans and your record keeping system is a vital part of producing reports that are accurate. One of the worst things that you could do at this stage is skimping on your record keeping system and quite literally losing track of someone’s money.
You may also keep records yourself by using accounting or payroll software if you have the knowledge to do so.
(Step 5) Get the word out to your current and prospective employees
So you’ve taken all the right steps to set up a 401(k) for your business; It’s time to let your employees know! Establishing a 401(k) plan is a big step that the members of your company are sure to appreciate so talk about it. Call a meeting and explain the benefits of enrollment and use this as a time to educate them on the financial benefits of participation. While 401(k) may just seem like a buzz word in the corporate world, it will have a noticeable impact on employee satisfaction and it can go a long way in improving the long term quality of life of your best advocates. Here are some methods that you can use to inform employees about their new benefits:
Call a formal meeting
Inviting a financial advisor that was involved in the plan’s creation can be a great extra step to take to increase employee’s confidence in your plan.
Even if it is you who leads the meeting, a sit-down in a face to face setting will allow your employees to ask critical questions and it will also foster trust.
Send out a company wide email
As a business owner, you likely understand the power of email. Your employees use email daily to communicate so why not provide them with information on their new benefits where they are sure to find it?
Host an informal celebratory event
Get everyone together for a casual party after work and make a short 2-3 minute speech about the company’s progression and your appreciation for your staff who made this possible.
This is a great option because everyone loves food and drinks, not to mention it is an excellent way to foster a sense of community within your company.
Create educational content on financial health
Financial wellness is something that is rarely taught in the workplace, but doing so shows that you care about the future of your employees in a way that many other employers simply do not.
Hosting an internal financial seminar can open the eyes of your employees to the impact that proper money management can have on their lives and it is a perfect time to emphasize the importance of enrollment in your new 401(k) plan.
Enroll them that very day by guiding them through the enrollment process, or show them how they can manage their account if auto-enrollment is a feature of your plan.
Call one-on-one meetings to discuss the plan
If you have a smaller team, a much more personal way to introduce employees to their new benefits is to meet with them individually. You can guide them through the plan and teach them how to enroll and manage their account.
This can be nerve racking if you’re not experienced in the personal finance arena which is why you can always invite a financial advisor that you trust to answer the difficult questions for you. Taking this extra step can show your employees that you have put a considerable amount of time and effort into providing them with not only financial opportunity but also quality information.
While getting the word out to your employees should be your primary focus, it shouldn’t be your only one. Don’t forget that many job seekers will pass on a job opportunity if another offer features a 401(k). Now that you have one, make sure that you drive that point home in interviews and within your job postings. Here are a few ways to get the word out to prospective employees:
Post on social media (personal & company accounts)
Use your social influence to your advantage by leveraging your social media accounts. 79% of job applicants use social media in their job search, meaning that touting your employee benefits on Facebook, Instagram, Twitter and LinkedIn could be a deciding factor in the level of talent that you attract to your business.
Spread the word in professional associations
As a business owner, you understand the power of networking and word of mouth. It will never go out of style so why not use that to your advantage?
If you’re a part of an association, talk to your fellow members about your new offerings. If you’re not a part of one yet, find one in your area and use it to scout promising jobseekers. Start your search with directories such as the Directory of Associations which lists over 35,000 local, regional, national and international associations.
Speak about workplace engagement, corporate social responsibility or employee advocacy
All of these topics have one thing in common: they put your company’s most valuable stakeholders first in your company’s priorities. Whether your goal is to foster a sense of community, provide financial wellness for employees in a time where few other institutions will or advocate for the rights of those that work under you, a 401(k) plan implementation in your business will align with your goals.
Become a thought leader in your industry by standing up for your beliefs and use your new 401(k) benefits as support for your long-term goals. It wouldn’t be wise to speak on these subjects if they are not a part of your core beliefs as a business, however if they are then it could be a good time to get out there and show the world that you are committed to empowering those who work along side you.
Managing Your Account(s)
Now that you know how to set up 401(k)s, whether you own a business or work at one, you should look into how to manage your accounts. Take account of your situation in life and use your financial plan or budget to decide on how much you can afford to put aside to save for retirement. Next, research the investment choices that are offered within your plan and choose the one that is right for you.
Review your 401(k) annually or semi-annually to reassess your progress. You may realize that you have some extra funds that you can apply to your 401(k) after refinancing your student loans, paying off a car note, or receiving a promotion. Rebalancing your account may be necessary as your life goals change in order to take a more aggressive or conservative approach to your investment.
At this stage, you should seriously consider speaking with a financial advisor as they may have retirement strategies that can optimize your retirement savings account. Enrolling in a 401(k) is simple when compared to the steps involved in properly growing that account.
Having a person that does all the heavy lifting for you in terms of research, paperwork, and due diligence can save you from several potential headaches down the road. In the event that you change your job, suffer a financial tragedy, or if you ever see the need to make changes to your business plans, having an advisor in your corner that can bring years of financial experience to the table will be invaluable. Having that person around could potentially save you thousands in taxes and other associated fees.
Do you still have questions? We’ve got you covered…
Reach out to us and we will be more than happy to provide you with answers. We promise we won’t bite!
Written by Magdalena Johndrow, MSc, CFS®
Maggie is a Partner and Financial Advisor at Johndrow Wealth Management. She attended Providence College and the London School of Economics prior to beginning her career on Wall Street at Barclays and JP Morgan. She has taken her experience with high net-worth clients and used it to empower families and small businesses.
