Chapter 2 — 401(k) Plans

Cash or Deferred Arrangements (CODAs) — more commonly called 401(k) plans — have become one of the most popular retirement vehicles in the United States. These plans allow employees to elect to have part of their current compensation contributed to a qualified profit-sharing or stock bonus plan. In many plans, employers also contribute on behalf of employees, typically by matching employee contributions according to a preset formula.

Because a 401(k) plan must be part of an underlying profit-sharing or stock bonus plan, it must comply with the general qualification rules that apply to all such tax-advantaged plans. As with other qualified plans, contributions receive favorable tax treatment — most contributions are tax-deductible and earnings grow tax-deferred until withdrawn.

Like all qualified plans, 401(k)s may not discriminate in favor of highly compensated employees in terms of coverage, contributions, or benefits. To satisfy this nondiscrimination requirement, a 401(k) plan must pass several tests, including an Actual Contribution Percentage (ACP) test and an Actual Deferral Percentage (ADP) test.

Distributions from 401(k) plans are generally treated like distributions from other qualified plans. However, the rules governing withdrawals allow for distributions for financial hardship — which most other qualified plans do not permit. Another important feature is the availability of plan loans, subject to restrictions to ensure they are genuine loans and not disguised distributions. These provisions make 401(k) plans more liquid than most other retirement vehicles.

401(k) plans are generally structured as one of the following types:

Under a bonus-type plan, contributions are not usually made until the end of the year when a traditional bonus is declared for all employees. After the bonus is declared, each employee may elect to receive the bonus in cash or defer it into the plan. Some plans require an all-or-nothing approach; others allow the employee to split the bonus and receive part in cash and contribute part to the plan.

Under a thrift-type plan, an employee opts to receive a reduced salary — or foregoes a salary increase — and has the difference contributed to the plan on their behalf. The 401(k) contribution (a fixed percentage of salary) is deducted from each paycheck and contributed to the plan. Employees may typically change their contribution levels once or twice a year, though there are no legal restrictions on how often the contribution amount may be changed.

Employers that do not maintain any other qualified plan and employ 100 or fewer employees may adopt a Savings Incentive Match Plan for Employees (SIMPLE) as a 401(k) arrangement. The primary advantage is that the complex nondiscrimination tests applicable to regular 401(k) plans are automatically satisfied if the plan meets the simpler contribution and vesting requirements of SIMPLE plans. SIMPLE 401(k) plans must still satisfy all other qualified plan rules and 401(k)-specific requirements. Annual contribution levels for SIMPLE plans are lower than for regular 401(k) plans — the 2026 SIMPLE deferral limit is $17,600 ($3,850 catch-up for age 50+; $5,250 super catch-up for ages 60–63).

A Solo 401(k) (also called an Individual(k)) is a 401(k) plan designed specifically for owner-only businesses — defined as a business that employs only the owner and immediate family members, or one whose only non-family employees are part-time workers who may be excluded from participation under federal coverage rules. Like SIMPLE plans, Solo 401(k)s eliminate much of the administrative burden of regular 401(k) plans. Unlike SIMPLE plans, however, Solo 401(k) plans allow the higher funding levels available under regular 401(k) plans — up to $72,000 in annual additions (2026).

Roth 401(k) plans allow employees to make nondeductible (after-tax) elective contributions into a designated Roth account within the plan. Contributions grow tax-deferred and qualified distributions are tax-free — similar to Roth IRAs. Key updates under SECURE Act 2.0:

• Beginning in 2024, Roth 401(k) accounts are no longer subject to required minimum distributions during the owner’s lifetime, aligning them with Roth IRA rules.
• Beginning in 2026, employees with prior-year FICA wages exceeding $150,000 must make all catch-up contributions as designated Roth contributions if the plan offers a Roth option.

Virtually any employer — whether a corporation, partnership, or sole proprietorship — can establish a 401(k) plan (government bodies are excluded). Owner-only businesses would typically opt for the Solo 401(k). Smaller employers with 10 to 250 employees represent the best market for regular 401(k) plans. The best prospects are employers that:

• have a stable workforce,
• do not currently maintain a retirement plan,
• have a profit-sharing plan with an inconsistent history of contributions,
• would like to shift a portion of the funding burden to employees,
• find their existing defined benefit plan too cumbersome or costly to maintain,
• have outgrown their SIMPLE plans,
• have a substantial percentage of well-paid employees, and
• are growing and profitable.

In addition to the general rules that apply to all qualified plans (discussed in Chapter 1), 401(k) plans must satisfy the following special requirements. The plan must:

• be part of a profit-sharing, stock bonus, pre-ERISA money purchase, or rural cooperative plan,
• require no more than one year of service to participate,
• offer employees the option of receiving possible deferrals in cash,
• limit annual elective deferrals to the applicable dollar limit ($24,500 in 2026),
• meet special 401(k) requirements relating to nondiscrimination, elective deferrals, and distributions,
• provide for separate accounting of the different types of employer and employee contributions, and
• not require plan participation as a condition for receiving other employee benefits.

Unlike other qualified plans that may require up to two years of service, 401(k) plans must be open to any employee who has completed at least one year of service. Employers may set shorter eligibility periods but not longer. Additionally, under SECURE Act 2.0, long-term part-time employees who work at least 500 hours per year for two consecutive years must be eligible to make elective deferrals.

To qualify as a 401(k) plan, the amount an employee may defer as an elective contribution must be available to the employee as cash. A plan that offers the employee a choice of a non-cash benefit (such as health insurance coverage) or deferral of an equal amount will not qualify under Section 401(k).