401(k) Plan

How a 401(k) works

The employee picks a percentage of pay to contribute. Payroll takes it out each pay period and sends it to the plan's recordkeeper, where it is invested in funds the employee chooses from the plan's menu, or in a default fund such as a target-date fund.

• Traditional (pre-tax) deferrals reduce taxable income now and are taxed when withdrawn.
• Roth deferrals are taxed now, and qualified withdrawals in retirement are tax-free.

Both types are still subject to Social Security and Medicare tax. Withdrawals before age 59½ generally carry a 10% additional tax on top of income tax, with exceptions. Employer contributions, whether a match or a profit-sharing contribution, may be subject to a vesting schedule.

2026 contribution limits

The IRS adjusts limits annually. For 2026:

• Employee elective deferrals: $24,500
• Catch-up for age 50 and over: an extra $8,000
• Higher catch-up for ages 60 to 63: $11,250 instead of $8,000
• Total annual additions (employee plus employer, excluding catch-up): $72,000

From 2026, under SECURE 2.0, employees whose prior-year FICA wages from the employer exceeded the indexed threshold ($150,000 for 2026 catch-ups) must make catch-up contributions as Roth. Plans that do not offer Roth cannot accept catch-ups from those employees, so check your plan design with your recordkeeper.

Employer match and safe harbor 401(k) plans

Common match formulas include 50% of the first 6% (a 3% maximum match), 100% of the first 4%, and 100% of the first 3% plus 50% of the next 2%. The formula shapes behavior: employees tend to contribute exactly the amount needed to get the full match, so 'up to 6%' nudges people to save more than 'up to 3%.'

Traditional 401(k) plans must pass annual nondiscrimination tests (the ADP and ACP tests) showing that highly compensated employees are not saving disproportionately more than everyone else. Companies with low participation among hourly staff fail these tests and have to refund contributions to their higher earners.

A safe harbor 401(k) avoids most of that testing in exchange for a required employer contribution that vests immediately. The standard options are:

• Basic match: 100% of the first 3% deferred plus 50% of the next 2% (4% maximum)
• Enhanced match: at least as generous as the basic match, commonly 100% of the first 4%
• Nonelective contribution: 3% of pay to every eligible employee, whether or not they contribute

Safe harbor plans are popular with mid-size employers that have a mix of salaried and hourly workers. Some also pair the plan with profit sharing.

Auto-enrollment and part-time eligibility

SECURE 2.0 requires most new 401(k) plans established after December 29, 2022 to automatically enroll eligible employees, starting with plan years beginning in 2025. The initial default rate must be between 3% and 10%, rising 1% a year to at least 10% (and no more than 15%). Employees can opt out. Small businesses with 10 or fewer employees, businesses less than three years old, church plans and governmental plans are exempt. Older plans are not required to auto-enroll but many choose to.

Auto-enrollment is the single most effective way to raise participation among hourly staff. Plans with it commonly see participation of 85% or more, against well under two-thirds for opt-in plans.

Long-term part-time employees also gained rights. For plan years starting in 2025, employees who work at least 500 hours in two consecutive years must be allowed to make deferrals. For employers with large part-time populations, such as retail, contact centers and healthcare, this needs to be tracked in the HRIS.

401(k) for employers: fiduciary duties and common errors

Sponsoring a 401(k) makes the employer a fiduciary under ERISA. That means acting in participants' interest, keeping fees reasonable, monitoring investments, and following the plan document. Common operational errors:

• Late deposit of deferrals. The Department of Labor requires deferrals to be deposited as soon as they can reasonably be separated from company assets. Small plans (under 100 participants) have a seven-business-day safe harbor. Larger employers should aim for a few days at most.
• Wrong definition of compensation. If the plan says bonuses count and payroll excludes them, every participant's deferral and match is wrong.
• Missed eligibility. New hires or rehires not offered enrollment on time. Corrections can require employer-funded make-up contributions.
• Not filing Form 5500 each year.

Correction programs exist through the IRS and DOL, but self-auditing each year is far cheaper.

Using the 401(k) in recruiting and retention

For salaried candidates, a strong match is a real differentiator. For hourly candidates, it rarely beats an extra dollar an hour in a phone screen, but it does shape who stays. A match with a three-year cliff vesting schedule can reduce turnover around the second anniversary, though it can also feel punitive if not explained. Be clear about vesting in the offer and in your total rewards statement.