401(k) Plans

A 401(k) plan is a qualified (i.e., meets the standards set forth in the Internal Revenue Code (IRC) for tax-favored status)  plan under which an employee can elect to have the employer contribute a portion of the employee’s cash wages to the plan on a pre-tax basis. These deferred wages (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reflected as taxable income on the employee’s Form 1040, U.S. Individual Income Tax Return.

The employer reports elective deferrals on the participant’s Form W-2, Wage and Tax Statement. Although these amounts are not treated as current income for federal income tax purposes, they are included as wages subject to social security (FICA), Medicare, and federal unemployment taxes (FUTA).

401(k) plans are permitted to allow employees to designate some or all of their elective deferrals as “Roth elective deferrals” that are generally subject to taxation under the rules applicable to Roth IRAs.

Two of the tax advantages of sponsoring a 401(k) plan are: Employer contributions are deductible on the employer’s federal income tax return to the extent that the contributions do not exceed the limitations described in section 404 of the Internal Revenue Code.  Elective deferrals and investment gains are not currently taxed and enjoy tax deferral until distribution.

Traditional 401(k) plans. A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested. Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

Highlights of Traditional 401(k)s

• Can be set-up by any employer other than a state or local government entity
• Participant’s retirement benefits based upon participant’s account balance
• Allows employees to contribute to their own retirement through salary deferrals, up to $16,500 and an additional $5,500 if age 50 or older
• Although not required, the employer can contribute to an employee’s retirement account
• The maximum combined employer and employee contributions are the lesser of 100% of an employee’s compensation or $49,000  or more if catch-up contributions
• May exclude certain employees from coverage as long as annual coverage tests are met
• More complex to set up and operate
• Annual return usually required
• Must usually satisfy annual nondiscrimination testing
• Greater design flexibility
• Plan may allow loans and hardship withdrawals
• Immediate vesting in employee’s own contributions

Safe harbor 401(k) plans. A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.

Highlights of Safe harbor 401(k)s

• Can be set-up by any employer other than a state or local government entity
• Participant’s retirement benefits based on participant’s account balance
• Allows employees to contribute to their own retirement through salary deferrals, up to $16,500 and an additional $5,500 if age 50 or older
• Employer is required to make annual minimum contributions
• The maximum combined employer and employee contributions are the lesser of 100% of an employee’s compensation or $49,000 or more if catch-up contributions
• May exclude certain employees from coverage as long as annual coverage tests are met
• More complex to set up and operate
• Annual return could be required
• Some annual nondiscrimination testing could be required
• Greater design flexibility
• Plan may allow loans and hardship withdrawals
• Immediate vesting in full account balance

Matching contributions. If the plan document permits, the employer can make matching contributions for an employee who contributes elective deferrals to the 401(k) plan. For example, a 401(k) plan might provide that the employer will contribute 50 cents for each dollar that participating employees choose to defer under the plan.  As mentioned earlier, employer matching contributions may be subject to annual tests to determine if nondiscrimination requirements are met.

Other employer contributions. If the plan document permits, the employer can make additional contributions (other than matching contributions) for participants, including participants who choose not to contribute elective deferrals to the 401(k) plan. If the 401(k) plan is top-heavy, the employer may be required to make minimum contributions on behalf of certain employees. In general, a plan is top-heavy if the account balances of key employees exceed 60% of the account balances of all employees.

Employee compensation limit. In 2010 and 2011, no more than $245,000 of an employee’s compensation can be taken into account when figuring contributions.

Vesting requirements. All employees must be fully (100%) vested in their elective deferrals. A plan may require completion of a specific number of years of service for vesting in other employer or matching contributions. For example, a plan may require that the employee complete 2 years of service for a 20% vested interest in employer contributions and additional years of service for increases in the vested percentage.

 

**Source: http://www.irs.gov/retirement/sponsor/article/0,,id=151800,00.html