A 401(k) plan is a form of a profit sharing plan that allows employees to defer a portion of their compensation into the plan on a pre-tax basis (before Federal, and in many cases State taxes) to the plan.
A 401(k) plan is funded by employees' salary deferral and in some cases additional employer contributions. An employee can annually contribute the lesser of up to 100% of their salary or $19,500 (2021 - Indexed). The 401(k) plan must adhere to a special nondiscrimination test that limits the amount highly compensated employees can contribute from their salary to a multiple of the average amount contributed by non-highly compensated employees.
Employers may provide a discretionary matching contribution. The matching contribution must be vested at the rate of 20% per year, beginning after two years of service (100% vested with 6 years of service). A faster vesting schedule may be provided at the employers option.
Employees age 50 and over are eligible for a "catch up" contribution of $6,500 in 2021.
The advantage of a 401(k) plan is that the employees bear the cost of the deferral contributions to the plan. Although no employer contributions are required, most companies make matching contributions to the plan to encourage employee participation.
The disadvantages are the maximum annual deferral contribution is only $19,500 per participant (for 2021), and nondiscrimination testing (referred to as "ADP testing") limits the annual deferral amounts for owners and highly compensated employees based upon how much the non-highly compensated employees defer.