Many people think that to set up a 401(k) plan, they simply need to get an investment contract set up, and start sending in contributions! It’s actually a little bit more complex, so this page outlines some of the basics of 401(k) plans for beginners so you don’t get sold a package that may not be right for your company.
WHAT IS A 401(k) PLAN?
A 401(k) plan is a profit-sharing plan that allows for an employee to take money from his/her paycheck to be deposited to the plan. The plans are called 401(k) because this provision is outlined in Section 401(k) of the Internal Revenue Code.
ARE CONTRIBUTIONS TAX-DEDUCTIBLE?
Yes. Employee contributions are typically done on a pre-tax basis. Contributions are exempt from federal and state withholding, but are subject to all other payroll taxes including employer payroll taxes.
For example: If my paycheck is $1,000, and I save $50 in the plan that period, federal and state income tax withholding is calculated as if I only earned $950 that period. In this case, my take home pay wouldn’t drop by $50, but maybe $42. The $8 difference is from the reduced tax rate.
401(k) contributions are reported on Form W-2 prepared by employers at the end of the year, so employees don’t have to do anything else on their personal income tax return at the end of the year.
ARE AFTER-TAX CONTRIBUTIONS ALSO AVAILABLE?
Some plans also offer an after-tax option for employees called a Roth 401(k) option. Any plan that offers a Roth option must also offer a pre-tax option. The employer may allow you to do one or the other option, or a combination of the two.
HOW MUCH CAN I DEDUCT FROM MY PAYROLL FOR THE 401(k) PLAN EACH YEAR?
Every calendar year you can save 100% of your pay up to a maximum of $16,500 (this is the 2011 limit, and may change for 2012). The $16,500 is the maximum whether you make a pre-tax or Roth contribution. This is your personal contribution limit. You may be restricted to less than this maximum if you are considered a “Highly Compensated Employee.” See the question about “testing” below for more information.
If your employer makes a contribution to the plan it does not reduce your personal $16,500 limit.
If you are age 50, or if your 50th birthday will be this year, you may also save an additional $5,500 for an increased total contribution of $22,000 (in 2011). This is called a “catch-up” contribution.
CAN MY EMPLOYER MAKE CONTRIBUTIONS TO THE PLAN?
Yes, your employer can make one of two types of contributions to the plan:
- Matching contribution – this is a match of your personal contributions. If you make no contributions to the plan, then you will get no match.
- Employer contribution – this is a contribution made to employees who are eligible for the plan. You are not required to make personal contributions to be eligible for the employer contribution.
Employer contributions are deductible on the business tax return, and are always treated as a pre-tax contribution. Employer contributions are typically optional in a 401(k) plan except in certain circumstances.
CAN THE EMPLOYER RESTRICT WHO GETS TO SHARE IN THE CONTRIBUTIONS THEY MAKE?
Yes, sometimes there may be restrictions to the employer contributions. You may be required to:
- Meet the plan’s eligibility requirements before you become eligible to receive the employer contributions
- Work a minimum number of hours during the year
- Be considered an active employee at the end of the year
- Work for a minimum number of years before you are “vested” in your employer contributions
CAN I START A 401(k) PLAN ON MY OWN?
401(k) plans must be set up (sponsored) by an employer. If you are a sole proprietor you may be able to set up a 401(k) plan for your business.
IS THERE ANY SPECIAL TYPE OF TESTING FOR 401(k) PLANS?
Yes, each year there are compliance tests that each 401(k) plan must pass. Employers who set up a plan are responsible to make sure that this testing is performed accurately each year. If they choose to outsource this responsibility they should make sure that they understand what is being done for them.
Step 1 – determine which employees are Highly Compensated Employees (HCE): These are employees who either:
- own more than 5% of the company sponsoring the plan,
- are a family member of a 5% owner (spouse, child, or parent), or
- earned more than $110,000 in the prior year from the company sponsoring the plan. This category may be restricted to the top 20% of wage earners only if elected in the plan document.
Step 2 – determine which employees are Key Employees. These are employees who either:
- own more than 5% of the company sponsoring the plan,
- are a family member of a 5% owner (spouse, child, or parent),
- are an officer in the company sponsoring the plan and earns more than $160,000 per year from the company, or
- own more than 1% of the company sponsoring the plan and earned more than $150,000 in the prior plan year.
Top heavy test: When the Key Employees hold 60% of the plan assets or more, the plan is considered “Top Heavy”. Top Heavy plans are required to make a minimum contribution to non-key employees. This minimum contribution is the lower of:
- 3% of pay, or
- the amount the Key Employee with the largest contribution to the plan (including personal contributions) deposited to his/her account during the year.
401(k) compliance test: This is called the Actual Deferral Percentage (ADP) test. The average deferral is determined for each employee by dividing their personal contribution by their eligible payroll. The average deferral of the employees in the Highly Compensated Employee (HCE) group is compared to the average deferral of the employees Non-Highly Compensated Employee (NHCE) group. The HCE group’s average cannot exceed the NHCE group’s average by a certain amount:
If the NHCE average is then the HCE maximum is
0%-2% 200% of the NHCE average
2%-8% 2% + the NHCE average
Over 8% 125% of the NHCE average
Matching contribution compliance test: This is called the Actual Contribution Percentage (ACP) test. This is performed just like the ADP test above, except it is determined for each employee by dividing their matching contribution by their eligible payroll. The average match of the employees in the HCE group is compared to the average match by the employees in the NHCE group.
If either the 401(k) or the matching contribution compliance tests fail, the employer must fix the test within 2½ months after the end of the plan year. The tests can be fixed by either:
- Bringing the average of the HCE group down by returning personal contributions (ADP) or matching contributions (ACP) to the HCEs with the highest personal contribution or matching contribution for that year, or
- Bringing the average of the NHCE group up by making an employer contribution to the Non-Highly Compensated Employees.
Failure to fix the ADP or ACP test using option “a” within 2½ months of the end of the plan year will require the employer to pay a 10% excise tax of the amount to be returned to the HCE group. If the Employer makes a contribution as outlined in option “b” there is additional time allowed without penalty.
WHAT IS A SAFE HARBOR 401(k) PLAN?
The Top Heavy, ADP, and ACP tests may be skipped for the year if the employer makes a “Safe Harbor” contribution of either:
- a matching contribution equal to 4% of an employee’s pay, or
- an employer contribution equal to 3% of an employee’s pay
The Safe Harbor contribution must be declared before the beginning of the plan year and must be in place for a minimum of three months during the year for new plans. All Safe Harbor contributions are immediately 100% vested.
WHAT OTHER TESTS MUST BE RUN?
Maximum contribution limits: Each plan participant is limited to an annual contribution (personal contributions, matching contributions, and employer contributions) of the lower of $49,000 or 100% of pay. The $5,500 “catch up” contribution, and any rollover contributions that the employee makes to his/her account are not counted in this limit.
Minimum coverage testing: The plan must be made available to most employees. Certain classes of employees may be excluded from eligibility (collectively bargained employees, employees who work overseas, etc.). Depending on the plan’s eligibility requirements, short-term or part-time employees may also be allowed to be excluded from participating.
In general, if all Highly Compensated Employees receive an employer contribution, at least 70% of Non-Highly Compensated Employees must also receive an employer contribution as well.
WHERE ARE THE PLAN CONTRIBUTIONS SENT?
There are a variety of options for managing funds within a 401(k) plan. Most mutual fund companies, insurance companies, brokerage houses, and banks have 401(k) products. Funds may be managed by professional money managers or by the plan participants themselves. Contact your favorite investment advisor and ask for a referral to someone who specializes in retirement plan asset management.
WHEN CAN MONEY BE WITHDRAWN FROM THE PLAN?
Retirement plans like a 401(k) have restrictions on when funds can be withdrawn. Benefits (other than Roth accounts) are subject to tax when withdrawn, and if withdrawn prior to age 59½ may also be subject to a federal excise tax of 10% of the amount withdrawn. Distributions are reported on a Form 1099R. Times when funds can be withdrawn include:
- Triggering events. If one of these events happen, a withdrawal is allowed:
- Retirement age is reached (this age is defined in the plan document)
- Disability of the participant (typically means total and permanent disability)
- Death of the participant (funds are paid to the participant’s beneficiary)
- Termination from service with the employer
- Hardship. Some plans may allow for an employee to withdraw funds if they are suffering a personal financial hardship such as:
- Medical expenses not covered by insurance
- Purchasing a primary residence
- College tuition expenses
- Funeral expenses
- Disaster recovery
- In-service withdrawals. Some plans may allow for employees to withdraw funds while they are still working. Withdrawals may be limited to:
- Employees age 59½ or older
- Employer contributions that have been in the plan for two years or more
WHAT ABOUT LOANS?
A plan may allow for employees to borrow funds from their accounts. In general, loans have strict rules:
- The maximum loan is 50% of your vested account balance, but no more than $50,000.
- Loans must be paid back with interest. The interest charged is often tied to the Prime Rate charged by banks plus some percentage (e.g., prime rate + 2%).
- Loan payments must be made at least once per quarter, but are typically paid through payroll deduction. It is up to you to make sure your loan payments are made! You can’t blame the payroll department if they fail to process your payments properly.
- Loans must be fully repaid within five years. Some plans may offer a longer payment period for residential loans.
- Most plans limit the number of loans an employee can have at one time.
ARE THERE ANY MANDATORY FILINGS FOR A 401(k) PLAN?
Yes, there is an annual Form 5500 filing required for most plans. This filing must be submitted to the Department of Labor within 7½ months after the end of the plan year. If there are more than 100 employees eligible for the plan, a CPA audit must be attached to the annual Form 5500 filing.
WHO CAN HELP ME CUSTOMIZE A 401(k) PLAN FOR MY COMPANY?
Most companies rely on the services of a Third Party Administrator (TPA) to help them with:
- Plan design – drafting a customized retirement plan document that suits their needs
- Testing – making sure all testing is performed accurately and in a timely manner, and corrected if there is a problem
- Filings –usually preparing the Form 5500 filing for you
Now that you understand 401(k) plan basics, you will be able to interview professionals to help you design and build your plan. Design the plan first and then plug in the investments you think best fit your needs. A good TPA will take good care of your plan and will provide fiduciary protection for you. A good investment advisor will be a specialist in retirement plans, and will be able to provide some fiduciary protection on the investment selection and monitoring process. If you have any other questions or would like more information about 401(k) plans, please click here and fill out the form, and we will be happy to provide you with more information!