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401(k)
The 401(k) is one of the most popular forms of retirement plan. It is a defined contribution plan that is a cash or deferred arrangement. Employees can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes, to the 401(k) plan. Employers may, at their discretion, match a portion of these contributions.
The employee contribution limit for 2026 is $24,500. Employees over 50 have a "catch-up" provision, which lets them contribute an extra $8,000 in 2026. The SECURE 2.0 Act allows an exception for those who are 60-63. Their catch-up amount is $11,250 in 2026 instead of $8,000.
Getting started. A 401(k) plan may be established with the help of an insurance or investment company. Employees may decide, within the established limits, how much of their salary to set aside for their 401(k).
SECURE 2.0 requires that all new plans established after December 29, 2022, automatically enroll new employees with an initial contribution amount between three and ten percent of salary, increasing by one percent per year, until contributions reach ten to fifteen percent of salary. However, an employee may elect to make deferral amounts based on their own choices and not the auto-enrollment rules, or they may choose not to make automatic deferrals at all.
Let's take a look:
Zelda makes $50,000 a year and invests $4,000 in a 401(k). So, her taxable income is only $46,000. Zelda won't be taxed on the earnings that accumulate in her account until she makes a withdrawal (typically after the age of 59 ½).
If Zelda chooses to withdraw funds prior to age 59 ½, she'll suffer 2 specific consequences. She'll have to:
- pay federal income taxes on the money immediately
- and
- pay a 10% penalty
As with any employer-sponsored plan, it's important to educate your employees. Employers typically use workshops, seminars, printed materials and/or Internet content to educate their employees on retirement investment options.
Eligibility. Who is eligible for your 401(k) plan?
- Employees 21 years of age or older who have worked more than 1,000 hours in a 12-month period
- OR li>Long-term, part-time employees, defined as any employee who in each of 3 consecutive years worked at least 500 but less than 999 hours, and is 21 or older
Two Types of Plans
Traditional 401(k) Plans - eligible employees make pre-tax elective deferrals through payroll deductions. Employers have the option of making matching contributions which may be subject to vesting requirements. Traditional plans are subject to nondiscrimination requirements and must meet annual tests to verify that the plan does not favor highly compensated employees.
There are two nondiscrimination tests an employer must conduct annually: the Actual Deferral Percentage (ADP) test, and the Actual Contribution Percentage (ACP) test.
The ADP test compares the average deferral – 401(k) elective deferral divided by compensation calculated as a percentage - of all eligible plan participants who are not highly compensated employees, with the average deferral of highly compensated employees. If the required standard is not met, corrective action must be taken, or the plan could lose its tax-qualified status.
The ACP test is similar but compares matching and after-tax contributions with the participant’s compensation. Penalties are the same if the standard for not highly compensated employees compared to highly compensated employees is not met.
These rules encourage management to get employees to defer more into their 401(k). The more employees defer, the more management can defer.
There is one other annual test that must be met known as the top-heavy test. Realistically, it applies to small organizations and requires that the plan balances of owners and highly compensated employees not exceed 60% of total plan assets.
Safe Harbor 401(k) Plans - similar to a traditional plan, but the employer is required to make matching contributions that are fully vested when made. These plans are not subject to annual nondiscrimination testing or top-heavy testing unless discretionary contributions are made such as profit-sharing contributions. This kind of 401(k) plan is most popular with small organizations.
Employer contributions. 401(k) employer matching contributions are an easy way to increase employee participation and satisfaction. Organizations typically match a percentage of an employee’s salary up to a specified limit.
Here's how it works:
Savannah works for Company X and makes $50,000 per year. Company X matches 50% of 10% of her salary. So, Company X will match 50% of $5,000 or $2,500.
403(b)
A 403(b) tax-sheltered annuity (TSA) plan is a retirement plan, similar to a 401(k) plan, offered by public schools and certain tax-exempt organizations. An individual may only obtain a 403(b) annuity under an employer's TSA plan. The contribution limit and catch-up are the same as for 401(k) plans.
The SECURE 2.0 automatic enrollment and 60-63 catch-up contribution provisions also apply to 403(b) plans.
Memory Jogger
Max made $55,000 in 2025 and invested $5,500 in his 401(k). How much was his taxable income for 2025?