401(k) Plans

401(k)s are very popular retirement savings plans offered by businesses of all sizes. These plans can be ‘standalone’ with or without an employer matching feature or combined with a profit sharing plan. (Refer to PROFIT SHARING PLANS.) The 2011 401(k) deferral limit for individuals is $16,500. Employees age 50 and over may defer an additional $5,500 for a maximum of $22,000. Contributions must come from payroll withholding. Employees can defer (i.e. contribute) 100% of their current income (after payroll taxes). There are currently five different 401(k) plans. Below are the two most common.

Traditional 401(k) Plan

In a traditional 401(k) Plan, eligible employees save federal and state (CA) income taxes on their deferred contributions or earnings until withdrawn. The employee voluntarily elects a portion of his/her compensation to be ‘deferred’ into a 401(k) account. * Check with your individual state to confirm its position on 401(k) pre-tax savings.

Employers do not have to offer matching contributions, however, by doing so, more employees are encouraged to participate making the required “ADP” IRS compliance test easier to pass. The “ADP” non-discrimination compliance test applies to the 401(k) elective deferrals. In addition, if there are employer matching contributions, those contributions are subject to a separate “ACP” non-discrimination compliance test. Each traditional 401(k) Plan is required to comply with the “ADP” compliance test, and if applicable, the ACP compliance test, annually.

Safe Harbor 401(k) Plan

The IRS realizes that the non-discrimination testing requirements of a traditional 401(k) Plan are problematic for small businesses. The Safe Harbor 401(k) Plans were, therefore, developed as an alternative to help companies sponsor 401(k) Plans without the worry of the non-discrimination tests.

Under a Safe-Harbor arrangement, the “ADP” testing requirement is waived in lieu of a mandatory company contribution. These safe-harbor contributions must be fully vested at all times.

There are two ways to satisfy the safe-harbor requirement. The first is with a Safe Harbor Non-Elective Contribution (“NEC”). This “NEC” requires the company to make a contribution equal to 3% of compensation to all eligible employees regardless if they have elected to participate.

The second option for satisfying the safe-harbor requirement is with a Safe-Harbor Match. With this option, the employees must contribute to the plan in order to receive a matching contribution. The Match requires the company to contribute a maximum contribution of up to 4% of compensation. There are two different match formulas available. The first is a 100% match on the first 4% of compensation an eligible employee contributes into the plan.

The second is 100% match on the first 3% of compensation contributed plus a 50% match on the next 2% of compensation contributed.

The Safe Harbor provision must be adopted before the beginning of the Plan Year and a special Notice is required to be distributed to all employees. There is a minimum three month Plan Year in some circumstances.

Starting in 2006, companies who sponsor a 401(k) Plan can also offer a ROTH 401(k) feature as part of the Plan. The Roth 401(k) is similar to the Roth IRA in that after-tax money is being saved and grows tax-free, but, as the name implies, the new account falls under 401(k) rules.

  • There are no limitations for eligibility.
  • A Roth 401(k) feature can be added to any type of existing 401(k) Plan.
  • Money can be withdrawn tax and penalty-free at age 59.5 as long as the account has been held for at least five years.
  • Roth 401(k) accounts share the same contribution limits of regular 401(k) Plans (2011 $16,500 or $22,000 for employees age 50 and older).
  • Participants have the choice of contributing pre-tax, after-tax or a combination of both. Any company contributions are still made on a pre-tax basis.
  • Participants may rollover Roth 401(k) contributions into a Roth IRA when they retire or leave the company.
  • The Roth 401(k) feature has the same distribution requirements as the traditional 401(k). Required distributions are still mandatory beginning at age 70.5.
  • Existing 401(k) Plans that offer a Roth 401(k) feature are now permitted (after 09/27/2010) to re-characterize non-Roth funds into Roth funds. The process is referred to as an ‘internal Roth conversion’ and is considered a distribution subject to Form 1099R reporting.