The American financial system can seem like a knot. How do 401k contributions work? This simple question can lead employees and employers alike down a rabbit hole regarding retirement plan contributions, federal and state income tax, and more. Luckily, we’ve unraveled this mess for you, and we are here to supply you with the basics of 401k contributions. 

How Do 401k Contributions Work: Understanding The Basics

Investopedia defines a 401k as “a retirement savings plan offered by many American employers that has tax advantages for the saver.” In other words, employers offer to contribute a portion of an employee’s salary, often matched by that employer up to a set limit, to a savings plan that is not meant to be drawn from until that employee retires. 

The type of 401k offered by the employer or selected by the employee determines the tax benefits employees will experience. We explain this more in-depth in our blog post on the topic, but here are the main points regarding different 401k plans:

• Traditional 401k: Traditional 401k contributions are tax-free as they are placed into the account. A traditional 401k is perfect for employees that want to frontload their 401k benefits by enjoying the tax-free contributions to the account. These employees are also okay with their funds being taxed as they are pulled out. 
• Roth 401k: A Roth 401k neglects the up-front benefits of a traditional 401k and taxes the account as funds are placed into it. Conversely, this means the funds will not be taxed as they are withdrawn from the account. This is great for employees that are fine with being taxed more in the present day to enjoy untaxed withdrawals from the account when they retire.

In short, if you ask, “How do 401k contributions work?” you wish to know which type of 401k is best for you and your employees, you can stop here. Each person’s financial situation is different, and the type of taxation on their 401k benefits that will serve them the best depends entirely on that situation.

Contribution Limits

Once you understand the different types of 401k, it’s essential that you next understand how contribution limits work. From year to year, the annual contribution limits for 401k plans are set by the IRS. These limits rise and fall according to multiple factors, the principal being inflation. 

The IRS has set the 2023 contribution limit at $22,500, up from 2022’s limit of $20,500. The rise in contribution limits for 2023 means that many individuals and organizations will have to rethink their contribution strategy, given that they are being allotted more room to operate. For more information regarding the rise in contribution limits, visit the official IRS website.

What to Do After Learning About 401K

Now you’ve done your research and at least understand how a 401k plan works. You’re familiar with contribution limits, the types of 401k, and how those types will best serve your employees. What’s next?

• Speak with your employees. Now that you’re armed with the knowledge necessary to help them decide which plan is best for them, you must have that conversation with your employees. Chances are that your employees are relying on you to assist them in making these decisions, and it is your responsibility as the provider of their livelihood to help them to the best of your ability. 
• Keep your information up-to-date. As mentioned in the section regarding contribution limits, 401k guidelines, rules, and regulations can change yearly. Therefore, to avoid being caught off-guard by a drastic change in contribution limits or other policies, regularly visit the IRS website and reference any other supplemental material regarding 401k plans to stay ahead of any changes that may occur.
• Implement your contribution plan. Once you’ve thoroughly researched how 401k plans work and how best to serve your employees’ best interests, you must take the time to implement them. For more information regarding the benefits of a 401k, read our blog post on the subject.

What to Do When 401k Contributions Get Overwhelming

As we mentioned in the introduction, it’s no secret that detangling rules and regulations regarding taxes, retirement plans, and general finances can be daunting. Especially for those that haven’t received adequate training or business education, navigating these rules can feel like walking through a minefield: one wrong step can tank your business or land you in hot water with the authorities.

To alleviate this stressor, consider working with Canal HR. Our team will help you improve your employee benefits package and ensure every detail of your company’s 401k plan is fulfilled. Your business retains complete executive control over your property and employees while enjoying a decreased workload due to outsourcing tasks. You can learn more about our services by visiting our website. 

Partnering with a PEO means that you and your team regain countless hours over the weeks, months, and years you would otherwise spend on tedious tasks that routinely draw your attention away from your business. This will allow you to spend more time working on the company and less time stressing about completing payroll for the week or learning about new guidelines for 401k contributions.

Serve Your Employees With Canal HR

As much as it’s about preventing your business from breaking the law, asking, “How do 401k contributions work?” is also about serving your employees. Providing them with the best 401k means that you’re actively improving their quality of life and future prospects. Continue to do the best for your employees by partnering with an organization like Canal HR. Canal HR has served businesses across the United States for over three decades, providing payroll administration, workers’ comp, risk management, and more. Learn more by visiting our website or contacting us directly.