How to Set Up a 401(k) for Employees

A 401(k) plan is an employer-sponsored retirement savings plan that allows workers to invest a portion of their paycheck before taxes. Investments grow tax-deferred until withdrawal during retirement. For many businesses, offering a 401(k) is part of a competitive compensation package to attract and retain talent.

Key Decisions in Plan Design

Before establishing a 401(k), an employer must make foundational decisions that define the plan’s rules and features. These choices determine how the plan operates, who can participate, and how contributions are handled.

Types of 401(k) Plans

A traditional 401(k) offers the most flexibility, allowing employers to decide whether to make contributions. These plans are subject to annual nondiscrimination testing, known as the ADP and ACP tests, to ensure they do not disproportionately favor highly compensated employees.

A safe harbor 401(k) automatically satisfies most nondiscrimination testing. To qualify, an employer must make specific, mandatory contributions that are immediately 100% vested, such as a 3% nonelective contribution to all eligible employees or a tiered matching formula.

A SIMPLE 401(k) is a cost-effective option for businesses with 100 or fewer employees. This plan is not subject to nondiscrimination testing but requires mandatory employer contributions, such as a matching contribution of up to 3% of compensation or a 2% nonelective contribution. SIMPLE plans have lower contribution limits than other 401(k) types.

Employee Eligibility

Employers must define when an employee can join the plan. Federal law requires plans to be offered to employees who are at least 21 years old and have completed one year of service, defined as 1,000 hours in a 12-month period. As of 2025, the SECURE 2.0 Act also requires eligibility for part-time employees who work at least 500 hours in two consecutive years.

Employers can choose more lenient rules, such as immediate eligibility. The plan must also specify entry dates, such as the first day of the month or quarter after an employee becomes eligible.

Employer Contributions

Matching contributions are a common way to incentivize participation, where the employer contributes based on an employee’s deferrals. A typical formula is a 50% match on the first 6% of an employee’s contributed pay. Nonelective contributions are made by the employer to all eligible employees, regardless of whether they contribute themselves.

Profit sharing is a discretionary contribution an employer can make, and the amount can vary each year based on the company’s performance. These contributions are allocated to eligible employees based on a formula defined in the plan document.

Vesting Schedules

Vesting determines when an employee owns employer contributions. Employee contributions are always 100% vested immediately. For employer funds, two common schedules are cliff and graded vesting.

A cliff vesting schedule requires an employee to complete a specific service period, up to a maximum of three years under Internal Revenue Code rules, before becoming 100% vested. A graded schedule allows an employee to gain ownership over time, such as becoming 20% vested after two years and an additional 20% each year until fully vested after six years.

Selecting a 401(k) Provider

After defining the plan’s structure, the next step is to choose a provider to administer it. This decision involves evaluating vendors based on their fees, services, and investment options.

Types of Providers

Providers include large payroll companies offering integrated services, traditional financial institutions with wide arrays of investment funds, and modern fintech platforms specializing in streamlined solutions. The best choice depends on the company’s size, budget, and desired level of administrative support.

Evaluation Criteria

When comparing providers, consider the following criteria:

• Fees: Evaluate all costs, including plan administration fees, per-participant fees, and investment expense ratios. Initial setup fees can range from $500 to $3,000.
• Investment Options: A good plan should offer a range of low-cost funds, such as index and target-date funds, to help employees build a diversified portfolio.
• Administrative Support: Assess the level of support for compliance testing, government filings, and recordkeeping. Some providers partner with a Third Party Administrator (TPA) for these tasks.
• Payroll Integration: Seamless integration with the company’s payroll system automates contribution processing and reduces the risk of administrative errors.

Required Documentation and Information

Before the plan can be established, the employer must gather specific information about the business and its employees. This data is used to create the legal plan documents, culminating in the plan adoption agreement.

Business Information

The provider will require the company’s legal business name, address, Employer Identification Number (EIN), and business structure (e.g., S-Corp, LLC). This information is used to create the plan’s legal framework and register it with government agencies.

Employee Census Data

A comprehensive employee census is required for setup. This file must include each employee’s full name, date of birth, hire date, and compensation details. Accurate census data is necessary for the plan to maintain its tax-qualified status.

The Plan Adoption Agreement

The plan adoption agreement is the legal document that formalizes all decisions made during the design stage. Provided by the 401(k) vendor, this document serves as the blueprint for the plan’s operation, turning design choices into legally binding rules.

The Implementation Process

With the plan designed and provider selected, the next phase is implementation. This stage involves executing legal documents, establishing the plan’s financial infrastructure, and enrolling employees.

Executing Legal Documents

The employer signs the completed plan adoption agreement to legally establish the 401(k). Service agreements with the 401(k) provider and any associated TPA are also signed, outlining the responsibilities and fees of each party.

Establishing the Plan Trust

A 401(k) plan’s assets must be held in a trust for the sole benefit of participants. The trust is a separate legal entity that holds all contributions and investment earnings. The provider guides the employer through setting up the trust and appointing a trustee to manage its assets.

Setting Up Payroll Integration

Connecting the 401(k) provider’s system with the company’s payroll software is an important step. This integration automates withholding employee deferrals and transmitting funds to the plan trust. The provider’s team will work with the employer to configure the connection and test the system.

Communicating and Enrolling Employees

Employers must provide eligible employees with a Summary Plan Description (SPD), a document explaining the plan’s rules. The provider supplies this and other enrollment materials. Employees are then guided through the enrollment process to select their contribution rate and investments.

Ongoing Plan Administration

Once operational, the employer has ongoing responsibilities to keep the plan in compliance with federal regulations. These duties include managing contributions, processing participant requests, and completing annual reporting to maintain the plan’s tax-qualified status.

Processing Contributions

A primary task is the timely remittance of contributions. With each payroll, employee deferrals must be deposited into the trust as soon as administratively feasible. Employer contributions must also be deposited according to the terms in the plan document.

Managing Distributions and Loans

The plan administrator processes participant requests for distributions and loans. When an employee leaves the company or retires, the administrator handles the distribution of their vested account balance, including tax withholding and rollover options. If the plan allows loans, the administrator manages the application and repayment process.

Annual Compliance and Reporting

Each year, the plan must undergo compliance checks. For traditional 401(k)s, this includes nondiscrimination testing to ensure the plan does not unfairly benefit high earners. If a plan is top-heavy, meaning over 60% of assets belong to key employees, minimum contributions may be required.

Most plans must also file Form 5500 annually with the Department of Labor, which is due seven months after the plan year ends. Failure to complete these tasks can result in significant penalties.