The Revenue Act of 1978 included a provision that resulted in Internal Revenue Code Section 401(k) Cash and Deferred Arrangements. Section 401(k) created incentives for employers to provide their employees with tax-deferred compensation to be saved for retirement purposes by setting aside money on a salary reduction basis. The payments that employers contribute to these plans are tax deductible. Employees also may contribute to these plans. For a traditional 401(k), the portion of income that employees elect to receive as deferred compensation up to legal limits set by the IRS, rather than as direct cash payments, is exempt from income taxes until the funds are withdrawn at retirement.
What is a 401(k) plan?
A 401(k) Plan is a defined contribution plan that is a cash or deferred arrangement. Employees can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes, to the 401(k) plan. Sometimes the employer may match these contributions. There is a dollar limit on the amount an employee may elect to defer each year. An employer must advise employees of any limits that may apply. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their own investments.
The amounts deferred under your 401(k) plan are reported on your Form W-2, Wage and Tax Statement. Although elective deferrals 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 you to designate some or all your elective deferrals as “Roth elective deferrals” that are generally subject to taxation under the rules applicable to Roth IRAs. The information contained in this article does not pertain to Roth 401(k) unless specifically stated.
Two of the advantages of participating in a 401(k) plan are:
- Elective deferrals to the plan and investment gains are not subject to federal income taxes until distributed from the plan.
- Elective deferrals are always 100% vested.
To qualify for the tax benefits available to qualified plans, a plan must contain language that meets certain requirements (qualification rules) of the tax law and operated in accordance with the plan’s provisions. The following is a brief overview of important qualification rules. It is not intended to be all-inclusive.
There are several types of 401(k) plans available to employers – traditional 401(k) plans, safe harbor 401(k) plans and SIMPLE 401(k) plans. Different rules apply to each. It is important that you become familiar with your plan so that you understand the special rules that apply to you. Information about the plan must be provided to eligible employees (i.e., employees eligible to participate in the plan) in the Summary Plan Description. An eligible employee may also submit a request in writing to the plan administrator for a copy of the plan document. The administrator may charge a reasonable fee for the copy.
Traditional 401(k) plan
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 time period 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.
Safe harbor 401(k) plan
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.
Employers sponsoring safe harbor 401(k) plans must satisfy certain employee notice requirements. The notice requirements are satisfied if the employer provides each eligible employee with written notice of the employee’s rights and obligations under the plan and the notice satisfies content and timing requirements.
In order to satisfy the content requirement, the notice must describe the safe harbor method used, how eligible employees make elections, any other plans involved, etc.
The timing requirement requires that the employer must provide notice within a reasonable period before each plan year. This requirement is deemed to be satisfied if the notice is provided to each eligible employee at least 30 days and not more than 90 days before the beginning of each plan year. There are special rules for employees who become eligible after the 90th day.
Both the traditional and safe harbor plans are for employers of any size and can be combined with other retirement plans.
SIMPLE 401(k) plan
The SIMPLE 401(k) plan was created so that small businesses could have an effective, cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans. As with a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.
For more information on traditional, safe harbor and SIMPLE 401(k) plans, see Publication 4222, 401(k) Plans for Small Businesses.
Restriction on conditions of participation
Any 401(k) plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.
Automatic enrollment in a 401(k) plan
A 401(k) plan can have an automatic enrollment feature. This feature permits the employer to automatically reduce your wages by a fixed percentage or amount and contribute that amount to the 401(k) plan unless you have affirmatively chosen not to have your wages reduced or have chosen to have your wages reduced by a different percentage. These contributions qualify as elective deferrals. This has been an effective way for many employers to increase participation in their 401(k) plans.
Elective deferral limits
The law, under IRC Section 402(g), limits the amount that you can defer on a pre-tax basis each year. See the 401(k) plan contribution limits.
Elective deferrals that exceed the 402(g)-dollar limit for a year or are recharacterized as after-tax contributions as part of a correction of the Actual Deferral Percentage (nondiscrimination) test are included in your taxable income.
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 specific nondiscrimination requirements are met.
Other employer contributions (profit-sharing)
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
No more than $280,000 in 2019 ($275,000 in 2018) of an employee’s compensation can be considered when figuring contributions. This limit is indexed for inflation.
You must be fully (100%) vested in your 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.
General rules apply to distributions from a 401(k) plan. Review your Summary Plan Description or plan document to learn how to apply for a distribution from your 401(k) plan. Your employer or the plan administrator can assist you with the steps that are necessary for you to receive your distribution.
For more information about the treatment of retirement plan distributions, refer to Publication 575, Pension and Annuity Income.
For more information, see ‘Additional Resources for 401(k) Plans.’
To Learn More
CMR & Associates provides independent insurance and retirement advice by reviewing your current retirement plans (Defined Contribution or Defined Benefit) healthcare or Property/Casualty insurance plans. Emphasis is on improving overall retirement plan performance, plan audits, and cost reduction. Through our proprietary database – The CMR Database® – we maximize access to the commercial insurance and retirement industries for greater options that will translate to improved programs and lower cost.
CMR & Associates will provide you with a no-cost service by reviewing your current retirement and insurance portfolios to make sure that your coverage and plans design is adequate and affordable. If you currently do not have a retirement program or insurance, we can assist you in finding the appropriate program at an affordable rate. Please email CMR Associates or call 877-447-4301 or 212-447-4300 for more information.
About CMR: CMR & Associates provides independent retirement and insurance advice by reviewing your current Property/Casualty, Group Benefit or Retirement programs to improve coverage and reduce cost. Through our proprietary database – The CMR Database® (comprised of some 13,000 brokers nationwide) – we maximize access to the retirement or commercial insurance industries for greater options that will translate to better plan designs, coverage and lower cost. Since 1999, we have saved clients over $120 million.