What is a 401(k) Plan?
Section 401(k) was added to the Internal Revenue Code by the Revenue Act of 1978.
This code section allows sole proprietorships, partnerships, corporations, and some tax exempt entities to sponsor a Profit Sharing Plan. The employer and employees are given the option of deferring a portion of their own income to the plan.
Additionally, the plan may contain an employer matching provision and/or an profit sharing provision.
What are the tax benefits of a 401(k) plan?
All 401(k) salary deferrals contributions made for employees are generally deductible to the individual for federal and state income tax purposes.
All matching and/or profit sharing contributions are generally deductible to the employer.
Salary deferral, matching, and profit sharing contributions made for employees are generally not included in their current taxable compensation for federal and state income tax purposes.
All contributions, except salary deferrals, are generally excluded from payroll taxes, i.e., FICA, FUTA, etc.
Investment earnings on plan assets are tax deferred.
When are taxes due?
All contributions and investment earnings are includable in the participant's gross income for Federal and State income tax purposes for the year in which the participant receives a distribution from the plan.
The participant may, however, continue to defer taxes if he or she directly rolls the distribution over to an Individual Retirement Account (IRA) or to another qualified retirement plan within 60 days of the day it was received.
Federal (10%) and State excise tax penalties may be due for premature distributions. This generally applies to participants under age 59½ as of the distribution date.
How much may be contributed to a 401(k) Plan?
The maximum employer contribution (employer matching and/or profit sharing contributions) is 25% of the total compensation of all eligible employees.
The 401(k) annual deferral limit for a participant is indexed and adjusted annually. Please see Technical Facts in the Resource tab for limits.
The 415 limit for a participant is indexed and adjusted annually. This limit refers to the sum of a participant’s salary deferral, matching, profit sharing, and forfeiture allocations. Please see Technical Facts in the Resource tab for limits.
Participants age 50 or older are eligible for a “catch-up” contribution which is not counted towards the overall 415 limit.
Must all employees be eligible to participate?
The plan may exclude union employees where retirement benefits were a subject in the collective bargaining agreement.
The plan may require employees to reach age 21 and to have at least 12 months of service before they are eligible for salary deferrals.
The plan may also impose class exclusions, hours of service requirements, and end of the year employment conditions.
Does a 401(k) Plan have a vesting schedule?
Salary deferral accounts must always be 100% vested. Matching and profit sharing accounts may be subject to vesting schedules.
Does a 401(k) Plan allow participant loans?
Employers may choose to add a loan provision to their plan.
Are participants allowed to self-direct the investments in their own accounts?
Yes. However, there are many factors and considerations that must be explored before a decision is made.
When may distributions be taken?
Distributions from 401(k) Plans are limited to the following events: death, total and permanent disability, attainment of the plan’s specified retirement age, termination of employment, military service, or other conditions (if the plan allows).
How does the salary deferral provision operate?
All eligible participants execute a Salary Reduction Agreement indicating the percentage of pay or the dollar amount they wish to defer per pay period. The employer withholds this amount and deposits it to the plan. The plan may allow the participant to increase, decrease, or cease salary deferrals at various times during the year and offer a special election for bonuses.
What is the Non-Discrimination test?
401(k) plans are subject to special non-discrimination testing. There are several tests but the Actual Deferral Percentage or ADP test is the most well known.
Under the ADP test, all eligible employees are divided into two classes; the “Highly Compensated” (HCE) and the “Non-Highly Compensated” (NHCE).
An employee is considered “Highly Compensated” if at anytime during the plan year or the preceding year:
If they were a greater than 5% owner of the employer at any time during the current year or preceding year;
If they received more than a specific amount of compensation from the employer in the preceding year (indexed by the IRS annually) and are among the top 20% of the employer's work force ranked in terms of compensation.
Note: Family members of a 5% owner may also be included in the “Highly Compensated” group.
All employees other than “Highly Compensated” are considered “Non-Highly Compensated.”
The first step in computing the ADP test is to calculate the average deferral percentage for the “Non-Highly Compensated” group. The maximum allowable average deferral percentage for the “Highly Compensated” group can then be determined by using the table at the right.
It is possible for companies to predict, with relative certainty, the amounts that their “Highly Compensated” groups can collectively contribute for the current year. 401(k) Plans are able to determine the ADP's for their “Highly Compensated” groups by comparing the ADP's of the “Non-Highly Compensated” groups from the prior year.
If the Actual Deferral Percentage for the “Highly Compensated” group is less than the allowable rate, the test is passed. If the percentage is higher, the test is failed.
If the test fails, the employer must either contribute to the “Non-Highly Compensated” participants so the plan will pass or the plan must return sufficient salary deferrals to the “Highly Compensated” group.
| Non-Highly Compensated | Highly Compensated |
|---|---|
| Average Rate | Maximum Allowable Average Rate |
| 1% | 2.00% |
| 2% | 4.00% |
| 3% | 5.00% |
| 4% | 6.00% |
| 5% | 7.00% |
| 6% | 8.00% |
| 7% | 9.00% |
| 8% | 10.00% |
| 9% | 11.25% |
| 10% | 12.50% |
| 11% | 13.75% |
| 12% | 15.00% |
The Safe Harbor 401(k)
The Safe Harbor 401(k) Plan is ideal for any employer who wishes to eliminate the burden of the discrimination testing associated with the traditional 401(k) plan.
This type of plan allows all employees to contribute up to the maximum yearly deferral limit (indexed annually by the IRS) as long as certain “safe harbor” conditions are satisfied.
In order to eliminate the discrimination tests, such contributions must be 100% vested when contributed.
Eliminating the average deferral percentage test; the ADP test would be satisfied if the plan fulfills either of the two following conditions (see right):
A matching contribution is made which equals at least 100% of the first 3% of compensation deferred and at least 50% of the next 2% of compensation deferred. A modified formula is permitted, as long as the total amount of the match is not less than what the statutory formula would produce and the rate of match does not increase as the rate of deferral increases. For example, a formula of 100% on the first 4% of deferred compensation would satisfy the requirements.
The employer contributes to all eligible employees, whether they defer under the 401(k) arrangement or not. The 3% contribution must be set by the plan document which may also provide that this contribution be made to only NHCE’s. The document may allow the employer the discretion to contribute more. Also, the non-elective contribution may be made to a separate defined contribution plan.
How does the employer matching provision operate?
Matching contributions may be fixed or discretionary. Fixed matching contributions are stated as a percentage of the salary deferral amount. There may be a dollar or a percentage of compensation limit. Discretionary matching contributions allow the employer to decide how much to contribute, if anything, from year to year. The employer may wait until after the end of each plan year to make this decision.
How does the profit sharing provision operate?
The employer determines how much to contribute at year end. All eligible participants will receive an allocation of the contribution whether they are deferring their own compensation or not.
When is a 401(k) Plan top heavy?
All qualified retirement plans, including 401(k) plans, are top heavy when the Key Employees are credited with more than 60% of the assets of the plan as of the end of the prior plan year. A 5% owner is always considered a Key Employee. Certain officers and 1% owners may be Key Employees based on compensation earned. Family members are assumed to have the same ownership if they are a parent, child, spouse or grandchild of an owner.
Is the top heavy test the same as the ADP test?
No. The ADP test compares the ratio of contributions between the Highly and Non-Highly Compensated Employees. The Top Heavy Test compares the assets of the plan as allocated between Key Employees and Non-Key Employees as of the beginning of a plan year.
What happens when a 401(k) Plan becomes top heavy?
If any Key Employee receives a contribution (including the Key Employee's own 401(k) salary deferral contributions) in the year that the plan is top heavy, the employer must make the same percentage contribution for all Non-Key Employees, up to but not in excess of 3%. For example, if the Key Employee makes a 10% contribution for himself, the employer must make a 3% minimum contribution for all of the eligible Non-Key Employees. The Non-Key Employee's own salary reduction contributions are not counted toward meeting the 3% minimum requirement.
Is it possible to become non-top heavy after the plan has been top heavy?
Yes. If the assets of the Non-Key Employees rise over 40% as of the end of a plan year, the plan will not be considered top heavy during the following plan year. Therefore, no minimum contribution requirement is necessary during the next year. However, the plan usually maintains the top heavy vesting schedule.
How may an employer benefit from a 401(k) Plan?
Attract and retain quality employees.
Low employer cost.
Flexible plan design.
How may an employee benefit from a 401(k) Plan?
Reduces income taxes as a result of deductible contributions and deferred earnings.
Provides a systematic approach to saving for retirement.
Allows for larger deductible contributions than other retirement savings vehicles.
What should an employer consider before adopting a 401(k) plan?
As an employer, it is important to establish objectives prior to the adoption of a plan due to the numerous options available in the design of a 401(k) Plan.
The employer should retain the services of a 401(k) Consultant to assist in establishing objectives and outline the plan design that will best meet those objectives.
The employer may wish to conduct a survey of employees to determine their level of participation. This may provide the employer insight into many other areas such as discrimination testing and employee cost.