401(k) – Basic Considerations
A 401(k) Plan is a type of Profit Sharing Plan with provisions that permit 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.
Common Features of a 401(k) Plan
The Eligibility Requirements of a plan must be met in order for an employee to become a participant in the plan. The plan sponsor may specify up to 12 months of service and, if desired, a minimum age (not greater than age 21) as requirements for eligibility.
Requiring 12 months of service to be eligible for the plan tends to exclude short-term and part-time employees. This tends to reduce the paperwork and expenses required for the enrollment and participation of such employees.
However, immediate entry into the 401(k) Plan may be an important recruitment factor. In such circumstances, a shorter eligibility period may be indicated. Please note that, with a service requirement of less than one year, part-time employees would also be included as eligible employees.
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, with entry dates of January 1 and July 1. If an employee completes his first 12 months of service on April 7, he does not enter the plan until July 1. This means that he cannot start deferrals until the first pay period that begins after July 1, even though he met the Eligibility Requirements on April 7.
You should notify participants of upcoming Entry Dates so that newly eligible employees have the opportunity to complete a Salary Reduction Agreement prior to the Entry Date.
Elective Deferral Contributions
The Salary Reduction Agreement amounts are known as “elective deferrals” (or “deferrals”). A participant’s deferral amount may not exceed the calendar year dollar limit set by the IRS ($18,000 in 2017), and may not exceed 100% of gross pay (in practice, the plan’s limit should be set to 90%, to allow for other withholdings). A participant age 50 or older may make an additional $6,000 “catch-up” deferral (2017 limit). Other plan limits or company contributions may also limit the percentage a participant can contribute to the plan.
Basic elective deferrals are taken on a pretax 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 a post-tax basis, rather than on a pretax 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).
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.
Timing of Payroll Submission
Due to IRS and DOL requirements, the employer should deposit employee deferrals in the trust and transmit payroll data as soon as administratively feasible after the pay period ending date, and should not consolidate multiple payroll periods on one payroll transmission or deferral deposit.
Deferral Change Dates
A deferring participant can elect to stop deferrals at any time. However, to otherwise change his deferral rate, or to commence deferring (if the participant has not been deferring), the participant may do so only on the plan’s Deferral Change Dates.
You should notify participants of upcoming Deferral Change Dates so that participants have the opportunity to submit a new Salary Reduction Agreement specifying any changes.
In addition to employee salary deferrals, there are two basic types of company contributions: company match contributions, and company discretionary contributions (also called “profit sharing” contributions). The match contribution is made to accounts of employees who deferred salary to the plan. The discretionary contribution is made to the accounts of all eligible employees.
As part of our service, Benetech will calculate all year-end company contributions based on census data you will verify after the plan’s year-end. These calculations are completed after Benetech has performed the plan’s discrimination testing to ensure the proper contribution amounts are calculated.
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.
Vesting of Benefits
Employee deferral accounts are always 100% vested. However, company match and discretionary contributions are subject to the plan’s Vesting Schedule. Participants who leave the company before they are 100% vested forfeit the non-vested portion of their accounts.
Recent tax law changes limit vesting schedules 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, to pay plan expenses, or are allocated to remaining participants.
Participant loans can permit access to retirement funds on a short-term basis without triggering tax consequences. However, plan sponsors are not required to offer a participant loan program.
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.
If the plan includes a Hardship Withdrawal provision, participants may withdraw funds from their elective deferral accounts under special circumstances of financial hardship, such as medical emergencies, secondary education, purchase of a primary residence, or to prevent eviction/foreclosure on a primary residence.
A participant taking a Hardship Withdrawal must stop deferring for 6 months after the receipt of the distribution. It is the plan sponsor’s responsibility to ensure that the participant does not defer during the 6 month period. It is also the plan sponsor’s responsibility to commence deferrals after the 6 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 usually also subject to a 10% excise tax. Also, the participant must first use funds available from other sources (for example, obtain a loan from the plan for the maximum amount) prior to applying for a Hardship Withdrawal.
Normal distributions of a participant’s account may occur when the participant terminates employment with the company, retires, or becomes disabled.
Participants may “roll” all of 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.
Elective deferral contributions are subject to an Actual Deferral Percentage (ADP) Test to demonstrate nondiscrimination.
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.
Highly Compensated Employees
Currently, Highly Compensated employees in the current year generally include the following:
- Any employee who received compensation in excess of $120,000 (limit for 12/31/17 test year, indexed) in the prior year.
- Any owner with an interest greater-than-5% in either the current year or prior year.
- The spouse of a greater-than-5% owner, as well as their children, parents and grandparents.
To pass the ADP Test, the average deferrals of the Highly Compensated group must bear a specific relationship to the average deferrals of the Non-Highly Compensated group.
- If the average deferral of the Non-Highly Compensated group is less than 2% of compensation, then the deferral percentage for the Highly Compensated group may be twice as much.
- If the average deferral percentage of the Non-Highly Compensated group is 2% or greater, but less than 8%, then the Highly Compensated group’s average may be two percentage points higher than the Non-Highly Compensated group.
- If the average deferral percentage of the Non-Highly Compensated group is 8% or greater, then the Highly Compensated group’s average may be 1.25 times the percentage of the lower group.
The Average Contribution Percentage (ACP) Test for match contributions by the company follows the same ratios.
If handled in a timely manner, the plan sponsor can choose from two simple solutions to ADP/ACP failure: the plan may “give back” to Highly Compensated employees deferrals sufficient to pass the test; or, the company may choose to make a Qualified Non-Elective Contribution (a “QNEC”) to all Non-Highly Compensated employees (QNECs are always 100% vested).
The “give back” solution must be completed within two and one-half months after the plan year end. If completed after this due date, the amount of the “give back” is subject to a 10% excise tax. The “QNEC” requires that the plan use the “current year” testing method.
To maintain maximum flexibility with regard to these solutions, be sure to review, sign and return the year-end package Benetech will send you after the close of each plan year. Benetech cannot accurately test your plan and calculate these solutions (if necessary) without the information requested in the year-end package.
Top Heavy Plans
This rule considers the trust accounts of “Key” employees (an owner; an owner’s spouse, child or parent; and certain other employees).
If 60% or more of the trust assets are in accounts of Key employees, the plan is considered “Top Heavy.” The following applies only if the plan is Top Heavy.
If a Key employee receives a benefit under the plan (including deferring salary), all Non-Key employees eligible for the plan (regardless of their participation in the “salary deferral” part of the plan) will receive a Top Heavy Minimum contribution from the company (not to exceed 3% of compensation).
For example, if the plan is Top Heavy and if a Key employee were to defer 3% or more under the plan, the company would be required to make a 3% contribution to the accounts of all eligible Non-Key employees (even if they have never deferred under the plan).
Safe Harbor contributions are intended to satisfy Top Heavy contribution requirements in most circumstances. However, in certain situations, plans using Safe Harbor matching contributions may be required to make Top Heavy Minimum contributions.
Tiered Profit Sharing Contributions
Although not required, a plan sponsor may also make a discretionary profit sharing contribution to a 401(k) Plan. By using the Tiered allocation method, as much as 90% of the contribution could be allocated to targeted employees.
The Tiered allocation method begins by splitting employees into different categories (for example, “Owners” and “All Others”). It then targets the owners (and, if desired, other important employees) for the maximum contribution, in exchange for a contribution to other employees of as little as 5% of compensation (subject to special age-sensitive discrimination testing).
The result is a plan design that may allocate as much as 90% of the plan’s total contribution to the accounts of the owners (up to $54,000 each if younger than age 50; up to $60,000 each for those age 50 or older as indexed, 2017). This could save a business owner thousands of dollars each year in employee contributions.
To further minimize company contribution costs, the Tiered allocation method is often combined with the Safe Harbor 3% Non-Elective Contribution. The Safe Harbor 3% NEC is included in the Tiered discrimination testing, but also allows owners and other Highly Compensated Employees to defer at the maximum rate.