FAQs – 401(k) Overview
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What is a 401(k) plan?
This information about 401(k) Plans is general in nature, and is not intended to be taken as a comprehensive description of the regulations covering qualified plan sponsorship.
A 401(k) Plan is a type of Profit Sharing Plan with provisions that permits employees to defer a portion of their income through individual Salary Reduction Agreements. The company contributes this elective deferral amount into the plan’s trust account, where the funds accumulate on a tax-deferred basis.
The amount deferred by the participant is not subject to federal income tax or (in most states) state income tax until it is distributed from the trust. However, the participant and the employer continue to pay Social Security tax (FICA) and Federal Unemployment tax (FUTA) on the gross wages before deferrals.
The company may elect to make additional contributions, including company matching contributions or discretionary profit sharing contributions.
What are Employee Deferral contributions?
Basic elective deferrals are taken on a pre-tax basis: they are not subject to federal or (in most states) state income taxes (though they are subject to FICA and FUTA taxes). These assets are then invested on a tax-deferred basis. However, the entire amount (both deferral basis and any gain) is subject to taxation when a taxable distribution is taken.
“Roth” elective deferrals allow a participant to make deferrals on an after-tax basis, rather than on a pre-tax basis. Roth deferrals are subject to normal payroll taxes at the time the wages are paid, but the entire amount (both Roth deferral basis and any gain) may be distributed tax-free (subject to certain restrictions on the timing of distributions). There is no compensation limit on a participant’s use of Roth deferrals, so owners and other Highly Compensated employees may take advantage of this option.
The participant’s deferral election generally is applied to all W-2 wages, including bonuses, overtime, etc. (that is, deferrals are taken from all W-2 wages). Alternative definitions of compensation could result in special discrimination testing.
What are company Match and Profit Sharing contributions?
Sponsoring a 401(k) Plan does not obligate the company to make a match or discretionary contribution. However, once made, participants are entitled to these contributions according to the plan’s Vesting Schedule.
When should the employer deposit employee deferrals?
Can participants elect to stop making deferrals?
The employer should notify participants of upcoming Deferral Change Dates so that participants have the opportunity to submit a new Salary Reduction Agreement specifying any changes.
How are benefits vested?
Vesting schedules for 401(k) Plans are limited to a maximum of a 6-year graded vesting schedule (beginning with 20% in the 2nd year, and increasing in 20% increments each year thereafter), or a 3-year “cliff vesting” (100% after 3 years). However, schedules more liberal than this may be used.
The forfeitures resulting from the use of a vesting schedule are generally used to reduce the employer’s cost of contributions, or to pay plan expenses.
What is “ADP” Discrimination Testing?
The nondiscrimination test for elective deferrals compares the average ADP of the eligible Highly Compensated Employees with the average ADP of the eligible Non-Highly Compensated Employees. The average deferrals of the Highly Compensated group must bear a specific relationship to the average deferrals of the Non-Highly Compensated group.
There are two standard correction methods for ADP failures. Each method has certain restrictions and deadlines by which they must be completed to avoid penalties.
Discrimination testing for matching contributions (“ACP” Testing) is subject to similar rules.
What are ADP ratios?
- If the average deferral of the Non-Highly Compensated Employee group is less than 2% of compensation, then the deferral percentage for the Highly Compensated Employee group may be twice as much (e.g., if the NHCE deferral rate is 1.5%, the HCE deferral rate may be 3%).
- If the average deferral percentage of the Non-Highly Compensated Employee group is 2% or greater, but less than 8%, then the Highly Compensated Employee group’s average may be two percentage points higher than the Non-Highly Compensated Employee group (e.g., if the NHCE deferral rate is 3%, the HCE deferral rate may be 5%).
- If the average deferral percentage of the Non-Highly Compensated Employee group is 8% or greater, then the Highly Compensated Employee group’s average may be 1.25 times the percentage of the lower group (e.g., if the NHCE deferral rate is 12%, the HCE deferral rate may be 15%).
The Average Contribution Percentage (ACP) Test for matching contributions by the company follows the same ratios.
What is the Current vs. Prior-year testing method?
The purpose of allowing the election of the prior year testing method is to give the employer the option of knowing what the testing rate for NHCEs will be early in the plan year (rather than after the end of the plan year). This allows the employer to communicate the expected average deferral rate limit to HCEs during the plan year so that they can modify their deferral rates if needed.
The testing method must be specified in the plan document, and any amendment of the method must be done prior to the end of the plan year in which the testing method is to be applied. Once the testing method has been changed from the prior year method to the current year method, it must remain on the current year method for at least five plan years.
Note on catch-up deferrals in ADP Tests. Deferrals for a catch-up eligible participant are not characterized as “catch-up” deferrals until a limit has been exceeded. This means that, in most cases, deferrals less than the 402(g) deferral limit are considered “regular” deferrals for purposes of the ADP test and calculating an ADP test correction (however, catch-up deferrals in excess of the 402(g) limit are not considered in the ADP test).
How does a Plan correct an ADP Test failure?
Return of Deferral Correction Method
Under the Return of Deferral Correction Method, the employer reduces the average deferral rate of the HCEs by an amount sufficient to pass the ADP test. The employer does so by processing a return of deferral to HCEs according to an IRS-required two-step method. This correction must be completed within two and one-half months after the end of the plan year in which it occurred. If completed after this due date, the amount of the return of deferral is subject to a 10% excise tax, payable by the employer.
Note on Return of Deferral Correction Method
This correction method is a two-step process specified by the IRS. First, the amount of the return is calculated based on how much each HCE has exceeded the NHCE average deferral rate. However, the actual return is taken first from those HCEs who have deferred the largest dollar amount. In certain situations, this could have the unexpected result that an HCE whose deferral rate has not exceeded the allowable HCE average deferral rate would still be required to take a return of deferral.
QNEC Correction Method
Under the QNEC Correction Method, the employer increases the average deferral rate of the NHCEs in an amount sufficient to pass the ADP test. The employer does so by making contributions to certain NHCEs that conform to IRS regulations and provisions specified in the plan document. QNECs are always 100% vested, and the plan document must specify the “Current Year” ADP testing method for that plan year.
Penalty for Late Corrections
Corrections not completed by the end of the following plan year are subject to correction by processing both the late “return of deferral” for the HCEs and the QNEC to the Non-HCEs.
What are Safe Harbor provisions?
The sponsor has two basic ADP Safe Harbor contribution options from which to choose: a 3% Non-Elective Contribution (“NEC”) to all eligible employees; or a mandatory matching contribution with a minimum match cap of 4% of compensation.
Once elected, all Safe Harbor contributions are mandatory for that plan year, and are required by law to be 100% immediately vested.
What are the benefits of Safe Harbor provisions? What should plan sponsors consider before implementing them?
- The plan is not subject to ADP testing.
- The plan is not subject to ACP testing provided matching contributions (if any) are within Safe Harbor guidelines.
- Safe Harbor contributions are intended to satisfy Top Heavy contribution requirements if there is no allocation of contributions (including the allocation of forfeitures) other than employee deferrals and ADP or ACP Safe Harbor matching contributions.
- ADP Safe Harbor contributions are 100% vested.
- Safe Harbor contributions, once elected, are required through such time during the Plan year (plus 30 days) that the Safe Harbor provisions are rescinded (in such case, the Safe Harbor protections do not apply for the entire Plan year).
- Safe Harbor notices must be distributed to participants on a timely basis.
- No allocation requirements may be imposed on Safe Harbor contributions: any Non-Highly Compensated Employee eligible to defer must also be eligible to receive the Safe Harbor contribution.
- Safe Harbor contributions must be made to all participants eligible for a contribution, including those terminated during the year.
- If specified in the plan document, Safe Harbor contributions may be restricted to Non-Highly Compensated Employees only (that is, the employer is not obligated to give Highly Compensated Employees a Safe Harbor contribution if the plan document does not require such a contribution).
- In-service withdrawals of ADP Safe Harbor contributions prior to age 59 ½ are not allowed (with certain limited exceptions).
- Allocation of employer contributions other than ADP or ACP Safe Harbor contributions (including the allocation of forfeitures) could trigger a required Top Heavy minimum contribution of 3% of compensation to all eligible participants (regardless of their actual deferral rate).
- Matching contributions that do not conform to Safe Harbor requirements would subject the plan to ACP testing.
When can a Safe Harbor plan be established?
Existing 401(k) Plans Cannot Change Mid-year
Due to the notice requirements, an existing 401(k) plan cannot adopt Safe Harbor provisions mid-year, but must post a notice at least 30 days prior to the next plan year for Safe Harbor provisions to be effective in the next plan year.
New 401(k) Plans
However, a new 401(k) plan with Safe Harbor provisions may be established at any time during the year provided that there are at least 90 days for participants to defer salary into the plan (for this purpose, an existing Profit Sharing Plan that is adding 401(k) provisions for the first time is considered a “new” 401(k) plan).
For example, a new Safe Harbor 401(k) plan with a plan year-end of December 31 must be in place and ready to accept participant deferrals no later than the first pay period after September 30.
To be considered a “new” 401(k) plan, the company cannot have sponsored another 401(k) plan in the 12 months prior to the effective date of the new 401(k) plan.
What Types of Safe Harbor contributions are permitted?
The plan document and safe harbor notice must specify the type of ADP Safe Harbor provision elected by the employer.
ADP Safe Harbor Non-elective Contribution (“NEC”)
A NEC is made to all participants eligible to defer, including those who choose not to defer. The NEC requires a minimum contribution of 3% of the participant’s compensation. A NEC can be used to help satisfy non-discrimination testing required by a Tiered 401(k) Plan, so this is the Safe Harbor contribution of choice for Tiered 401(k) Plans.
There is a “conditional” NEC option that may be implemented provided the plan is designed and operated properly, and additional notice requirements (described below) are met.
ADP Safe Harbor Match Contribution
The most common Safe Harbor match option is the “Basic Safe Harbor Match” which requires that the employer make a matching contribution at the following rates of employee deferrals.
• 100% match on the first 3% deferred
• 50% match on the next 2% deferred
This basic match formula requires an employee to defer 5% of compensation to receive the full employer match contribution of 4% of their compensation.
Alternatively, the employer may elect an “Enhanced Safe Harbor Match,” which is slightly more generous than the basic match. Many small employers prefer the simplicity of an Enhanced Safe Harbor Match of 100% capped at 4% of compensation compared to the stepped-rate of the Basic Safe Harbor Match.
Requirements for an ADP Enhanced Safe Harbor Match include: the match must be at least as generous as the Basic Match at all deferral rates; the match cannot be made on deferrals greater than 6% of the participant’s compensation; the rate of match cannot increase as the deferral rate increases.
ACP Safe Harbor Match
In addition to the ADP Safe Harbor options described above, the employer may elect plan document provisions that allow an additional “ACP Safe Harbor Match.”
Unlike ADP Safe Harbor contributions, this additional match may be subject to the plan’s vesting schedule, and in-service distributions are permitted. Assuming that this additional match meets certain requirements, it would not jeopardize the Safe Harbor status of the plan.
Requirements for a discretionary ACP Safe Harbor Match include: the match cannot be made on deferrals greater than 6% of the participant’s compensation; the total match contribution for a participant cannot exceed 4% of the participant’s compensation; the rate of match cannot increase as the deferral rate increases; no allocation requirements may be used that excludes any Non-Highly Compensated Employees.
What are the Safe Harbor Notice requirements?
Initial Safe Harbor Notice – Existing 401(k) Plans
An existing 401(k) Plan cannot add Safe Harbor provisions in the middle of a plan year. This is because, for an existing 401(k) Plan, the Safe Harbor notice must be distributed to participants between 30 and 90 days prior to the first day of the plan year in which Safe Harbor provisions are to be effective.
Initial Safe Harbor Notice – New 401(k) Plans
A new 401(k) Plan does not need to be in place for a full 12-month period provided there are at least three months left in the plan year. This is also true of amending an existing Profit Sharing Plan (with no 401(k) provisions) to add Safe Harbor 401(k) provisions mid-year.
This means a new Safe Harbor 401(k) Plan can be established as late as October 1st (assuming it has a December 31st plan year-end).
Conditional Safe Harbor Notice
If the employer is using the Safe Harbor Non-elective Contribution provisions (e.g., 3% to all eligible employees, including those who choose not to defer), a conditional notice (generally referred to as a “maybe” notice) may be used. This is a two-part notification process. The first part is similar to the requirements of the standard notice except that the notice states that the employer may make a Safe Harbor NEC for the upcoming year.
The second part is a supplemental notice that is subsequently distributed to employees no later than 30 days before the end of that plan year informing participants of the employer’s intention of making the Non-Elective Contribution for that plan year. The plan document also must be amended by the end of the plan year to require this Non-Elective Contribution if the plan document does not support automatically implementing the conditional Safe Harbor election in the supplemental notice.
If this notice is not distributed, then ADP/ACP testing is required for that plan year. If the plan is Top Heavy, then the 3% Top Heavy Minimum Contribution requirement must be satisfied.
Because of the added administrative complexity and potential Top Heavy contribution requirements of the “conditional” Safe Harbor NEC, most small employers prefer the standard Safe Harbor NEC, particularly if the plan is currently Top Heavy, or may become Top Heavy in the future.
When can a Safe Harbor Plan be removed or terminated?
- A notice to participants of the change must be made at least 30 days in advance of the Safe Harbor contribution being discontinued.
- The Safe Harbor contributions must be made on compensation paid through 30 days after the notice is distributed to employees.
- Employees must have a chance during this 30-day period to change their deferral elections.
- ADP and ACP testing would apply for the entire year (so Highly Compensated Employees may be required to take a return of deferral and/or match).
- If the plan is currently Top Heavy, Top Heavy contribution requirements (up to 3% of participants’ compensation) must be met for the entire year.
To cease a Safe Harbor NEC, in addition to the items above, the employer must have a substantial business reason for removing the Safe Harbor provisions prematurely.
Generally, a small employer would not remove Safe Harbor provisions or terminate a Safe Harbor 401(k) mid-year as this could trigger unexpected Top Heavy required contributions or may result in a return of deferrals to Highly Compensated Employees.
What are auto-enrollment provisions?
“Behavioral finance” studies have shown that, when it comes to making complex decisions, a person tends to postpone deciding. For many 401(k) participants, this tendency to procrastinate results in never actually enrolling in their company’s 401(k) plan.
On the other hand, studies of existing 401(k) plans with auto-contribution provisions have shown that such arrangements increase employee participation by making a person’s tendency to procrastinate work in favor of participating in the plan: inaction is a “positive” step towards enrolling in the plan
There are two principal types of auto-contribution arrangements:
- An Eligible Automatic Contribution Arrangement (EACA), which is the basic non-Safe Harbor auto-contribution arrangement; and
- A Qualified Automatic Contribution Arrangement (QACA), which provides a nondiscrimination test Safe Harbor, similar to a standard Safe Harbor 401(k) plan.
What should small employers know about auto-enrollment?
Also, auto-contribution arrangements may result in additional participant accounts with small balances. These additional accounts may entail additional administrative paperwork and increased fees for distributions and annual plan maintenance.
A small employer should carefully consider these additional costs and responsibilities prior to implementing auto-contribution provisions in their 401(k) Plan.
What are the requirements for an Eligible Automatic Contribution Arrangement (“EACA”)?
Opportunity to elect a deferral rate
Participants must have the option of electing to defer salary under the plan, including the option of not deferring any salary.
Deemed deferral rate
If a participant makes no election, the plan sponsor treats the participant as having elected to defer salary.
- The contribution-withholding rate used for this purpose by the plan sponsor must be a uniform rate of compensation. This rate may be increased over time, so long as the rate of increase is uniform as well.
- This assumed deferral rate remains in effect until the participant specifically elects to not have deferrals contributed to the plan, or to have them contributed at a different rate.
QDIA should be used
Auto-contributed deferrals are generally invested in a Qualified Default Investment Alternative (“QDIA”) unless or until the participant makes a positive investment election.
Plan amendment required
A plan amendment adding EACA provisions must be executed in order to implement an EACA.
A written notice describing the rights and obligations of this arrangement must be given to each participant to whom this arrangement applies. This notice must be given within a “reasonable period of time” prior to the beginning of the plan year, and prior to the first salary deferral being withheld under this arrangement for a newly eligible employee.
What content must be included in an EACA notice to participants?
- Annual Participant Notice: A notice given at least 30 days prior, but not more than 90 days prior, to the beginning of each plan year is considered reasonable.
- Newly Eligible Participant Notice: For participants entering the plan, a notice given not more than 90 days prior to the participant’s entry date, but no later than the date the participant enters the plan, is considered reasonable.
What are the available features for an EACA?
- ADP refunds may be distributed up to 6 months after the end of the plan year without being subject to a 10% excise tax (generally, these must be distributed within 2 ½ months to avoid the excise tax).
- Auto-contributions may be distributed without penalty if the participant makes an election within 90 days of the first salary deferral. This in an optional feature.