FAQs – Common Plan Features
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What are compensation limits for employees?
Plan compensation is usually defined as all W-2 wages, including bonuses, overtime, etc. Alternative definitions of compensation could result in special discrimination testing, and may greatly complicate plan operation and administration.
What compensation rules apply to owners?
Owners of non-incorporated businesses, such as sole proprietorships or partnerships, generally should report earned Self-Employment Income (“SEI”) prior to the application of the self-employment tax deduction or contributions to a retirement plan. Business owners should consult with their tax advisor for more information regarding SEI.
Please note that for owners of non-incorporated businesses with SEI, contributions to the plan for the owner will generally reduce the SEI compensation for plan purposes. Therefore, the SEI compensation for plan purposes may be much less after contributions to the plan for the owner than the initial SEI reported to Benetech prior to plan contributions.
SEI Example: Consider an owner-only Profit Sharing Plan with a starting SEI compensation (after the Self-employment Tax Deduction) of $100,000. The Profit Sharing contribution deduction limit of 25% in this case is $20,000, which is 25% of $80,000 (where $80,000 = the $100,000 starting SEI minus the $20,000 deductible contribution).
LLCs and certain partnerships may elect to be taxed as a corporation. Generally, only W2 compensation should be reported for owners in such cases. However, business owners should always consult with their tax advisor for more information on compensation to be used for plan purposes in such cases.
When are employees eligible to participate in a qualified plan?
The employer can require up to 12 months of service to be eligible for the plan, while still retaining the plan’s vesting schedule. The employer may also require a minimum age (not greater than age 21) for plan eligibility.
If 12 months of service is required, the plan may also require 1,000 hours of service during that 12-month period. If the service requirement is less than 12 months, no hours’ requirement should be used.
No more than 12 months of service may be required to be eligible for participation in the salary deferral part of a 401(k) Plan. However, up to 24 months may be required for participation in other parts of a Defined Contribution Plan or a Defined Benefit Plan so long as all participants are immediately 100% vested upon entering the plan (that is, for eligibility periods longer than 12 months, a vesting schedule may not be used).
Once an employee has met the Eligibility Requirements, they enter the plan on the next Entry Date. Generally, the plan would be setup with Entry Dates on two or more specific dates during the year.
For example, consider a plan requiring 12 months of service for eligibility, with entry dates of January 1 and July 1. If an employee completes his first 12 months of service on August 7, he does not enter the plan until the next plan entry date, which is January 1 of the next year.
Standard entry dates include twice annually (e.g., 1/1 and 7/1), quarterly, monthly or “immediately” upon satisfying the eligibility requirements.
The plan document may also specify a category (or categories) of employees that are excluded from the plan. However, a plan generally must cover at least 70% of the Non-Highly Compensated Employees who would otherwise be eligible (except for the exclusion) to satisfy coverage rules. Because of these coverage rules, most small plans do not exclude employees from the plan in this fashion.
What is a typical vesting schedule?
A Cash Balance plan has a shorter maximum vesting schedule, in that a participant must be 100% vested after three years.
When can participants take distributions from a qualified plan?
Each of these types of distributions requires notices and election forms. Always discuss distribution procedures with Benetech prior to authorizing a distribution to make sure all of the necessary paperwork has been provided.
What is a termination distribution?
Participants may “roll” the distribution into an Individual Retirement Account (IRA) and continue tax-deferred earnings, or they may elect to take a lump-sum distribution and pay the tax required.
Any taxable distribution before age 59 ½ (or age 55, with separation of service) may be subject to an additional 10% excise tax.
What is a participant loan?
If participant loans are allowed, the plan must have a written loan program that specifies the terms of the loans to be issued. There are specific procedures that must be followed when issuing loans, including providing the participant with required notices, election forms, an amortization schedule, etc.
Increased IRS regulations on loans have made these programs a greater administrative burden for the employer and can frequently increase the time and cost associated with the plan. On the other hand, a loan program may help to promote employee participation in the plan.
What is a hardship withdrawal?
Only the deferral contribution basis (that is, the original amount deferred) may be distributed. Gain on the contributions cannot be distributed in this manner.
A participant taking a Hardship Withdrawal must stop deferring for six months after the receipt of the distribution. It is the plan sponsor’s responsibility to ensure that the participant does not defer during the six-month period. It is also the plan sponsor’s responsibility to commence deferrals after the six-month period based on the participant’s election.
The ability to withdraw funds in the event of a financial hardship is generally an important feature included to promote employee participation.
Although the Hardship Withdrawal provision provides a level of flexibility, it is a taxable event for the participant and is subject to a 10% excise tax if the participant is under 59 ½.
Also, the participant must first use funds available from other sources (for example, obtain a loan for the maximum amount) prior to applying for a Hardship Withdrawal.
What is an in-service distribution?
Salary deferrals, Safe Harbor and QNEC contributions cannot be distributed prior to age 59 ½. Also, for distributions prior to 59 ½, other contribution types (e.g., profit sharing or match) must satisfy an “aging” requirement, in that to be eligible for distribution either the contribution type must be in the plan for at least two years, or the participant must have been in the plan for at least five years.
To avoid the difficulty in administering such distributions, an In-service Distribution option will often require the participant to be 59 ½ or older to be eligible for such distribution.
What is a “cash-out” option?
However, if the plan document includes a “cash out” provision, the plan sponsor may force out participants under a dollar limit (specified in the plan document, usually either $1,000 or $5,000) without the participant’s written consent provided the account balance is under $5,000 and the participant has been given the option to direct the distribution and certain other procedures are followed. These distributions are either sent directly to the terminated participant or placed in a custodial IRA rollover account depending on various factors.
For cash-out distribution limits between $1,000 and $5,000, the cash-out distribution must be placed in a custodial IRA rollover account, and the plan sponsor must have a written agreement with an IRA custodian for receiving these rollovers.