Explaining 401Ks to Employees

401Ks are a tricky thing. Everyone knows what they are…sort of. If you randomly stop someone Billy on the Street style and say “in exchange for a dollar, what’s a 401K?” they’ll probably tell you that it’s some kind of retirement savings plan. But when it comes to the nitty-gritty details, things can get a bit fuzzy.

When employees don't understand the full scope of their 401K, they're less likely to take full advantage of it, or even to value it as part of their employer's benefits package. In order to make the most of this investment, employers need to take the time to explain how it works to their employees.

So, if your company offers a 401K plan as a part of your benefits package, here's a quick rundown of the basics that you can share with your employees:

What exactly is a 401K?

401Ks are a type of retirement savings plan that is offered by many employers. They are named after the section of the Internal Revenue Code that governs them, which is section 401(k). Essentially, a 401K plan allows employees to save money for retirement with the incentive of receiving certain tax breaks, which will differ depending on the type of 401K. By making the most of the tax breaks, the money saved can grow faster than if it were subject to normal taxation, so it's an attractive way to help employees save money efficiently. The money that goes into a 401K is typically deducted from an employee's paycheck, which means that the employer takes care of the paperwork and any tax implications. Some employers offer their own contribution or “match,” meaning they’ll either put a set percentage or match what the employer puts into their 401K.

Another important benefit of a 401K is that the contribution levels are very high.

• For 2022, employees can contribute up to $20,500 to their 401K if they're under the age of 50 or $27,000 if they're 50 or over.
• The total limit, including both employee and employer contributions, is $61,000 for those under 50 or $67,500 for those 50 years old or over.
• The maximum contribution limits for other retirement investment vehicles, like an IRA, are much lower, which is why the 401K is such an attractive option for employers to offer as a benefit.

The importance of 401Ks

There are a few reasons why 401Ks are so valuable, both for employees and employers.

• For employees, saving for retirement is vital because it ensures that they will have a safety net of enough money to live on when they retire. It can be challenging to save money on your own, so the ability to have a portion of your salary automatically deducted and put into a savings account can be very helpful.
• Younger employees typically struggle the most with saving for retirement because they have competing financial priorities, such as buying a home or car or paying off student loans—so the ability to commit even a small amount to retirement is important, and it makes a business even more desirable if you offer a contribution or match.
• Compounding interest makes a big difference, so starting to save early gives money more time to grow.
• For employers, offering a 401K plan can help attract and retain employees. It's also a way to show that you are invested in your employees' long-term success. Employee benefits like 401Ks can be an essential part of creating a positive work environment.
• Additionally, if you provide a contribution, you’re essentially providing an extra incentive for employees to save for retirement, as for employees it feels like “free money.”

Different types of 401K plans

There are two types of 401K plans, traditional and Roth, and the way they are funded and taxed is a little bit different.

Traditional 401K:

• The employee contributes money to their 401K plan, and the contribution is typically deducted from their paycheck before taxes are taken out.
• This means that the contribution reduces the employee's taxable income for that year.
• The money in the traditional 401K then grows tax-deferred, meaning that the employee does not have to pay taxes on any investment gains or interest that accrues in the account.
• When the employee retires and starts taking money out of the account, that's when they pay taxes on the withdrawals at their normal income tax rate.

Roth 401K:

• The employee contributes money to their Roth 401K plan, and the contribution is typically deducted from their paycheck after taxes are taken out. This means that the employee does not get a tax break for the contribution in the year that they make it.
• The money in the Roth 401K then grows tax-free, meaning that the employee does not have to pay taxes on any investment gains or interest that accrues in the account.
• When the employee retires and starts taking money out of the account, they do not have to pay taxes on the withdrawals because they've already been taxed.
• The major difference between the two options is when the taxes are taken out.

How do you choose?

The answer to this question depends on a few factors. Here are a few things to consider:

• Are you in a high tax bracket now, or do you expect to be in a higher one when you retire? If you're in a high tax bracket now, it may make more sense to choose the traditional 401K so that you can get the tax break now. If you expect to be in a higher tax bracket when you retire, it may make more sense to choose the Roth 401K so that you can pay taxes at a lower rate now and not have to pay taxes on the withdrawals later.
• How much money do you think you'll need in retirement? If you think you'll need a lot of money in retirement, it may make more sense to choose the traditional 401K so that you can get the tax break now and have more money to invest. If you think you won't need as much money in retirement, it may make more sense to choose the Roth 401K so that you won't have to pay taxes on the withdrawals later.
• When do you want to access the money? With a traditional 401K, you can't access the money until you're 59 1/2 without paying a 10% penalty. With a Roth 401K, you can access the contributions at any time without paying a penalty. This can be helpful if you have an unexpected expense or need to access the money for another reason.

A decision support tool can also be instrumental in helping employees choose the right plans. When using Nayya, for example, employees can provide information on their health and financial goals. Through this information, and a short survey that asks questions such as "in retirement, do you want to live the same way you do now, live in a way that requires a bit more money, or will you need less money to live a comfortable retirement?" Nayya can provide employees with different real-life cost scenarios, and guide them to making the best contributions to the best plans to meet their goals.

A solid 401K plan is an excellent addition to any company's benefits offering. It supports employees in achieving their long-term saving and retirement goals and shows that the company cares about their wellbeing. Offering a 401K option and/or an employer contribution is a great way to attract and retain top talent—so make sure that employees have the information they need to make the most of this benefit!