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 that gives the sole proprietor, partners and employees the option of deferring a part of their own income to the plan. In addition, the plan may contain an employer matching provision and/or an employer profit sharing provision.

 

What are the tax benefits of a 401(k) plan?

  • All salary deferral, matching and profit sharing contributions made for employees are generally deductible by the employer for Federal and State income tax purposes.
  • All salary deferral, matching and profit sharing contributions made for sole proprietors or partners are generally deductible for Federal and State income purposes on their individual returns.
  • Salary deferral, matching and profit sharing contributions made for employees are generally not included in their 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 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 maximum annual deferral limit for a participant in 2014 is $17,500. This limit is indexed and adjusted annually.
  • The maximum annual limit (415 Limit) for a participant is the lesser of $52,000 or 100% of the participant’s adjusted compensation (gross compensation for plan purposes minus the salary deferral amount). This limit applies to the sum of a participant’s salary deferral, matching, profit sharing and forfeiture allocations.
  • Participants age 50 or older can contribute an additional $5,500. This “catch up” contribution does not count toward the $52,000 limit.

 

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 plan may exclude employees under the age of 21.
  • The plan may require employees to have at least 12 months of service before they are eligible for salary deferrals. Up to 24 months may be required for profit sharing contributions and/or employer matching contributions.
  • 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 the same vesting schedules that other qualified plans may use.

 

Does a 401(k) Plan allow participant loans?

Yes. 401(k) plans may allow loans to participants. The same rules that apply to other qualified plans also apply to 401(k) plans.

 

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 in this area.

 

When may distributions be taken?

Distributions from 401(k) Plans are limited to the following events  ¾ death, total and permanent disability, attainment of the retirement age specified in the plan, termination of employment or certain hardship conditions (if the plan allows).

 

How does the salary deferral provision operate?

All eligible participants execute a Salary Deferral Form indicating the percentage of pay or the dollar amount they wish to defer per pay period. The employer withholds this amount and contributes it to the plan. The plan usually allows the participant to increase, decrease or cease salary deferrals at various times during the year. The plan may also allow 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 ¾ 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:
    1. He or she was a 5% or more owner of the employer at any time during the current year or preceding year;
    2. He or she received more than a specific amount of compensation from the employer in the preceding year ($115,000 for 2013) and he or she is among the top 20% of the employer's work force ranked in terms of compensation.

      Note: Family members of a 5% owner may be included as part of 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 following table:

Non-Highly
Highly Compensated
Compensated
Maximum Allowable
Average Rate
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%
  • Since 1997, it has been 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.

 

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 ($17,500 for 2014 plus 5,500 for those age 50 or over) as long as certain “safe harbor” conditions are satisfied.

  • Eliminating the average deferral percentage test ¾  the ADP test would be satisfied if the plan fulfills either of the two following conditions:

    1. 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.
    2. 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.

  • In order to eliminate the discrimination tests, all contributions must be 100% vested when contributed. A non-elective Safe Harbor contribution or Safe Harbor Matching allocation may be used to satisfy the top heavy contribution requirement.

 

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 limit 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 the end of each plan year to make the decision.

 

How does the profit sharing provision operate?

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. The definition of a Key Employee is different than the definition of a Highly Compensated Employee. Key Employees are 5% owners, 1% owners with $150,000+ in compensation, and officers with $165,000+ in compensation. 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?

The vesting schedule for matching and discretionary employer contributions must be no longer than a six-year graduated schedule starting with at least a 20% vesting in the second year and graduating, in 20% increments, each subsequent year.

If any Key Employee receives a contribution (including the Key Employee's own salary reduction 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 employees.
  • Lower in employer cost than other types of plans.
  • Benefit only those employees who wish to save for their retirement.

 

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.
  • Provides excellent replacement for lost IRA deduction.
  • Possibly allows larger deductible contributions than an IRA.

 

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.

Once the basic plan design is completed, the employer may wish to conduct a survey of employees to determine their level of participation. This indicates whether or not participation would be adequate to warrant implementation of the plan. It also provides the employer insight into many other areas such as discrimination testing, employer matching and employees' overall perception of the plan.

If the survey results are favorable, the employer may wish to proceed with the adoption of the plan. If the results are negative, the employer may either decide not to adopt a plan or to change the features of the plan to result in a favorable survey.

 

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