The two primary types of defined-contribution retirement savings plans offered by employers are 401(k) plans and 401(a) plans. They take their names from Section 401 of the United States Internal Revenue Code, which defines them.
The principal differences between a 401(a) plan and a 401(k) plan are first in the types of employers that offer them and then in several key provisions regarding contributions and investment choices.
- 401(a) plans are generally offered by government and nonprofit employers, while 401(k) plans are more common in the private sector.
- While participation in a 401(k) plan is not mandatory, with a 401(a) plan, it often is.
- Employee contributions to 401(a) plan are determined by the employer, while 401(k) participants decide how much, if anything, they wish to contribute to their plan.
How 401(a) Plans Work
A 401(a) plan is normally offered by government agencies, educational institutions, and nonprofit organizations, rather than by corporations. These plans are usually custom-designed and can be offered to key employees as an added incentive to stay with the organization. The employee contribution amounts are normally set by the employer, and the employer is required to contribute to the plan, as well. Contributions can be either pre- or post-tax.
Because the sponsoring employer establishes the contribution and vesting schedules in a 401(a), these plans can be set up in ways that encourage employees to stay. Employee participation is often mandatory. If employees leave, they can usually withdraw their vested money by rolling it over into another qualified retirement savings plan or by purchasing an annuity.
The plan's investment choices are determined by the employer and tend to be limited. Government-sponsored 401(a) plans, in particular, may include only the safest, most conservative investment options.
How 401(k) Plans Work
A 401(k) plan is usually offered by private-sector employers. A traditional 401(k) allows employees to contribute pre-tax dollars from their paycheck to the account and take a tax deduction for their contributions. Roth 401(k)s, on the other hand, are funded with after-tax dollars and provide no upfront tax benefit. Employees decide how much they wish to contribute, up to limits set by the IRS, and many employers match at least a portion of their employees' contributions, although that is not legally required.
The employer sponsoring the 401(k) plan selects which investment options will be available to participants, though as a function of their fiduciary duty, they need to be careful to offer a wider range of options than the sponsors of 401(a) plans often do. Plans typically offer 15 to 30 investment options, though research has indicated that too many choices confuse participants.
However, with the passage of the SECURE Act of 2019, employees may find more annuity plans offered as investment options in their 401(k) plans. This is because the SECURE Act now protects employers from being sued should the annuity insurer fail to make annuity payments to the plan participants.
Assets in a 401(k) plan accrue on a tax-deferred basis and, in the case of traditional 401(k)s, are taxed as regular income when they are withdrawn. Withdrawals from a Roth 401(k) are generally tax-free.