We previously discussed the factors small business owners should consider when choosing a retirement plan. If you haven’t already read that article, you may want to start there.

If you’re looking to learn more about the 401(k), then you’ve come to the right place.

We had the occasion to interview Michael Raub from New York Life Insurance Company on Tax Talk about this topic. If you haven’t watched that episode yet, here it is.

What is a 401(k)?

A 401(k) is a defined contribution plan. With it, you make annual deductible contributions to your retirement account up to applicable contribution limits. Contributions are discretionary by employees and employers can offer a variety of matching options or profit sharing.

What are the contribution limits?

The employee contribution limits are $19,500 for 2020 with additional “catch-up” contributions of $6,500 for employees over 50. Employers may contribute additional funds up to the lesser of 25% of salary or $57,000 in 2020 . The total contributions (employee contributions + employer contributions) may not exceed 100% of your salary.

Advantages of a 401(k)

The are a few clear advantages of a 401(k) over other types of retirement plans available.

Advantage 1: Larger contributions

Because you can get the benefit of employee contributions PLUS employer contributions, you can get larger contributions from a 401(k) than from other types of plans. This has major implications for tax planning .

Advantage 2: Borrowing is permitted

Unlike some of the other plans available, borrowing is permitted from a 401(k). If you would like to retain the ability to borrow against these funds, a 401(k) may be your best bet.

Advantage 3: Roth option available

401(k)s permit post-tax or Roth contributions. This is important if you believe that your tax bracket will be lower today than it will be upon retirement.

This is a major advantage over other plans if Roth contributions are important to you.

Advantage 4: Discretionary Contributions

You can contribute $0 in one year and maximize your contributions in the next. For this reason, you have major flexibility. This is great for businesses with large income swings or for individuals who need total flexibility over their taxable income.

Disadvantages of a 401(k)

Unfortunately, there’s no perfect retirement plan. While there are several advantages to a 401(k) it also comes with disadvantages.

Disadvantage 1: You may have to cover employees

If you elect matching contributions or profit-sharing, you will be required to cover your employees in the same manner you are covered.

You will need to consider this if your goal was to merely maximize your contributions. If you do not want to cover your employees, you may not be able to use a 401(k); however, most matching plans are affordable since most employees do not contribute large sums.

On the other hand, if you are the only employee, this may not be a problem for you at all.

Disadvantage 2: Global contribution limits

The employee-side contribution, otherwise known as the “elective deferral contribution”, has a global contribution limit. That means it applies to all 401(k), 403(b) and SIMPLE-IRA plans you participate in.

If you have another job which provides one of these plans, you will have to consider the global contribution limits.

Disadvantage 3: Somewhat more administration is required

This is not to say that a 401(k) is administratively burdensome, but it certainly has modestly more maintenance than some of the other plans available. This can be mitigated by outsourcing plan administration to a professional fund.

The Verdict

Much like all of the types of retirement plans we’re going to analyze, there are situations in which this is the best plan. There are others in which it’s not. This may be the best choice for you if you do not have employees. This may also be the best choice for you if you need to make retroactive contributions.

The only way to determine the best account for you is to discuss it with a tax planning attorney.