401k Plans
A 401(k) Plan is one of the most flexible qualified retirement plans available. This type of plan allows for employee and employer contributions that are tax deferred and tax deductible.
Employee Contributions:
Pre-Tax Option – Each plan participant can defer part of his/her compensation to the plan as a pre-tax salary deferral, up to the allowable IRS limit* of $19,500 (2021 limit, indexed annually). Participants age 50 or older can also defer an additional catch-up contribution of $6,500 (2021 limit, indexed annually).
After-Tax Option (ROTH) – Each plan participant can defer part of his/her compensation to the plan as an after-tax salary deferral, up to the allowable IRS limit* of $22,500 (2023 limit), indexed annually). Participants age 50 or older can also defer an additional catch-up contribution of $6,500 (2021 limit, indexed annually).
*The IRS limit applies to the cumulative total of pre-tax and ROTH employee contributions.
Employer Contributions:
In addition to salary deferrals, an employer may make a profit sharing contribution of up to 25% of total participant covered compensation (IRS 404 limit**) as a tax deductible contribution for the Company. Additional employer contributions, such as company match or safe harbor contributions are also allowed in a 401(k) plan and are a tax deduction for the employer and may be subject to a vesting schedule.
**For tax deduction purposes, the total of all employer contributions (profit sharing, employer match and/or safe harbor) cannot exceed 25% of total participant covered compensation.
The total of all employee and employer contributions cannot exceed 100% of a participant’s compensation or $66,000 (2023 limit) and 50 or older limit to $73,500
Employer contribution formulas can be designed based on the Employer’s objective.
Basic (Pro-Rata) Employer Formula – each participant receives the same percentage of compensation as an employer contribution (up to the allowable IRS limits).
Integrated with Social Security – this allows a slight skewing of contributions in favor of employees making more than the Social Security wage base.
Tiered Employer Formula – splits participants into different category tiers (example: Owners and Others) and provides a maximum percentage of compensation to the owner for as little as 5% of compensation to all others. This formula is subject to age-based discrimination testing which benefits older owners.
Basic (Pro-Rata) Formula vs. Tiered Formula Analysis:
In both plans the owners are deferring the $26,000 maximum. However, the Tiered Formula increases the profit sharing allocation to the owners by $12,500 ($6,250 each), while – at the same time – lowering the company’s overall contribution by $16,774.
| Age | Salary | Basic Plan | Tiered Plan | Difference | |
| Owner 1 | 51 | $125,000 | $57,250 | $63,500 | $6,250 |
| Owner 2 | 55 | $125,000 | $63,500 | $63,500 | $6,250 |
| Employee A | 50 | $55,000 | $13,750 | $4,443 | ($9,307) |
| Employee B | 41 | $36,000 | $9,000 | $2,908 | ($6,092) |
| Employee C | 32 | $32,000 | $8,000 | $2,585 | ($5,415) |
| Employee D | 27 | $25,000 | $6,250 | $2,020 | ($4,230) |
| Employee E | 39 | $25,000 | $6,250 | $2,020 | ($4,230) |
| Total (including deferrals of the owners): | $157,750 | $140,976 | ($16,774) | ||
Employer Match Formula – provides an Employer contribution based on the amount of each participant’s total Salary Deferral. This formula can be a fixed amount or determined by the Employer on a discretionary basis each year.
Safe Harbor Formula – provides a required Employer contribution to each participant based on a percent of compensation (i.e. 3%) or a percent of their amount deferred (i.e. 100% of the first 4% of compensation deferred). This formula allows for the annual required non-discrimination testing that is required to be performed on Salary Deferrals to be waived, as Safe Harbor contributions are required and must be contributed and immediately vested each year.
A 401(k) Plan can also be combined with a Defined Benefit or Cash Balance Plan for plan sponsors looking for the largest tax deductible employer contributions and also the ability to allow for employee deferral contributions. Benetech is an expert in designing combined plan arrangements.