Sep 25, 2009


A qualified cash or deferred profit-sharing plan, usually referred to as a 401(k) plan because the special rules for these plans are found in Code Section 401(k), is a qualified profit-sharing or stock bonus plan that incorporates an option for participants to put money into the plan or receive it as taxable cash compensation. In other words, a 401(k) plan differs from a regular profit-sharing plan in that employees can participate in deciding how much of their compensation is deferred. Amounts contributed to the plan are not federal income taxable to participants until they are withdrawn; this is a significant advantage over contributions to a savings plan, which are taxable to the employee before contribution to the plan. However, 401(k) amounts for which the employee can elect to receive either cash or a plan contribution—elective deferrals—are subject to an annual limit of $9,500, indexed for inflation (2000 figure is $10,500).

A 401(k) plan can be an independent plan or the 401(k) feature can be included with a regular profit-sharing, savings, or stock bonus plan of the employer. The plan can be designed in a number of ways to combine both employer and employee contributions, or the entire plan can be funded through salary reductions by employees.

Eligible Employers

Section 401(k) plans can be adopted only by private employers, including tax-exempt organizations. They are not available to government employers. Government employers may be eligible to adopt Section 403(b) or Section 457 plans to provide results somewhat similar to 401(k) plans.

Advantages and Disadvantages

Section 401(k) plans are currently very attractive to employees. First, they have the basic attraction of all qualified plans—they provide a tax-deferred savings medium. But 401(k) plans have an additional advantage by giving employees an opportunity to choose the amount of deferral according to their individual need for savings. From the employee's viewpoint, a 401(k) plan appears much like an individual IRA, but with additional advantages: The 401(k) plan has higher contribution limits than an IRA, in certain cases it provides special averaging on qualifying lump-sum withdrawals, and the withdrawal provisions during employment are slightly less restrictive.

From the employer's viewpoint, 401(k) plans are favorable because the entire plan can be funded through salary reductions by employees. Thus, the plan provides no direct additional compensation costs to the employer. Because of the popularity of the plan with employees, partly due to good publicity for these plans in the media, the employer can obtain employee goodwill with this type of plan at a relatively low cost. There are also some actual dollar savings in using the 401(k) type of design, because salary reductions by employees may reduce employer expense for workers' compensation and unemployment compensation insurance by reducing the payroll subject to those taxes.

The 401(k) type of design has some disadvantages, but in reviewing these it is important always to ask disadvantages to whom and disadvantages compared with what? First of all, the $9,500 (indexed) annual limit on elective deferrals is lower than that for other types of qualified plan contributions. However, as a practical matter, this limit primarily affects highly compensated employees. Another disadvantage is that a 401(k) plan is a qualified plan and as such is much more complicated than simply leaving savings up to individual employees, either through individual IRAs or otherwise. Also, the 401(k) plan is a qualified profit-sharing plan, not a pension plan, so the employer's deduction is limited to 15 percent of the covered payroll. That is, the total of the employer contribution and nontaxable employee salary reductions cannot exceed 15 percent of covered payroll. Generally speaking, integration of a 401(k) formula with Social Security is not possible, but the 401(k) nondiscrimination rules nevertheless permit significant discrimination in favor of higher-paid employees. Section 401(k) plans are more difficult to administer than regular qualified plans because of the additional rules (discussed later) that must be satisfied. Deferral amounts must be 100 percent vested; thus, there is no opportunity for the employer to save on plan costs by making use of employee forfeitures on Section 401(k) deferral amounts. Finally, distributions to employees prior to termination of employment are more restrictive than for a regular qualified plan. However, these restrictions are more liberal than those for an IRA.

Employer Matching Contributions

Under this approach, participating employees can elect salary reductions, with the employer making a matching contribution to the plan. The employer share can be dollar-for-dollar, or some specified fraction of the employee's contribution. Matching can be limited to a specified percentage of each employee's compensation. For example, a plan might provide that an employee can elect salary reductions up to 6 percent of compensation, with the employer contributing an additional 1 percent of compensation for each 2 percent of employee salary reduction.

A significant advantage to this approach is that employer matching encourages plan participation by lower-paid employees. This helps to meet the qualification tests for 401(k) plans—the actual deferral percentage tests discussed later.

Employer Profit-Sharing Contributions

The plan also may provide for additional employer contributions not related to salary reductions by employees. These contributions can be completely discretionary or subject to a formula, as in the case of a regular profit-sharing plan. These contributions can be allocated in any manner permitted in a profit-sharing plan, including a simple uniform percentage of the participant's compensation as well as integration with Social Security or an age-weighted or cross-tested approach.

Employee After-Tax Contributions

The plan may permit employees to make additional after-tax contributions to the plan—that is, contributions not subject to the elective deferral rules and subject to income tax. These contributions are treated like employee contributions to a thrift or savings plan, discussed earlier.

Coverage Requirements

Because a 401(k) plan is a qualified profit-sharing plan, it must meet all the eligibility and coverage requirements discussed earlier for qualified plans in general. However, substantial additional participation by lower-paid employees may indirectly be required to meet the actual deferral percentage requirements applicable under Section 401(k) as discussed below.

Vesting of Employee Accounts

Vesting requirements in a 401(k) plan may depend on the source or identity of the plan contributions.

  • Nontaxable employee salary reductions or elective deferrals made under a Section 401(k) cash or deferral option must be immediately 100 percent vested.

  • Any after-tax employee contributions must be 100 percent immediately vested, as in qualified savings or thrift plans, discussed earlier.

  • Employer contributions to the plan must meet the usual vesting rules for qualified plans. That is, the plan must have a vesting schedule for employer contributions that at least meets one of the ERISA minimum vesting standards (five-year vesting or three- to seven-year vesting).

$9,500 Limit on Elective Deferrals

Code Section 402(g) imposes a $9,500 annual limit on elective deferrals for each plan participant. The limit is imposed on the total of elective deferrals under all 401(k) plans, Section 403(b) tax-deferred annuity plans, and SIMPLEs covering the participant. The plan may not permit elective deferral contributions in excess of this limit. The $9,500 limit is adjusted for cost-of-living changes (2000: $10,500).

Designing a Plan To Meet the ADP Tests

Obviously, it is critical to design the 401(k) plan so that the ADP tests are met; otherwise the plan will fail to qualify and all tax benefits will be lost. Fortunately, it is not as difficult as plan designers once believed and disqualifications are rare. Some of the methods used to ensure compliance are as follows:

  • Mandatory deferral. For example, an employer contributes 5 percent of compensation for all employees that must be deferred and allows an additional 2 percent under a cash or deferral option. This plan will always meet the second ADP test.

  • Limiting deferral by the higher paid. This approach involves administrative problems. The highly compensated group must be identified and deferral must be monitored, with a mechanism to stop deferrals at an appropriate point during the year if necessary. Alternatively, excess deferrals for highly compensated employees can be computed at the end of the year and corrective distributions, including interest earnings, made to affected employees. Such corrective distributions are income-taxable to the recipients and must be made within 2½ months after the end of the plan year to avoid an additional penalty tax. Instead of cash distributions if the plan permits after-tax contributions, these excess amounts can be retained in the plan and recharacterized as after-tax contributions within 2½ months after the plan year. Related matching contributions can be forfeited and generally cannot be distributed.

  • Counting on the popularity of the 401(k) approach. In actual practice, many companies find that participation by lower-paid employees is substantial. It is not unusual for 75 percent of all employees of an organization to participate in the plan. This may eliminate the problem without any special mechanisms coming into effect.

Because of the ADP tests, not every employer is suitable for a 401(k) plan. Because substantial participation by lower-paid employees is necessary, pay levels must be reasonably high in the organization, at least high enough so that some amount of retirement saving is possible by most of the employees.

Distribution Restrictions

Account balances attributable to amounts subject to the cash or deferral election—the 401(k) amounts—are subject to special distribution restrictions. These amounts may not be distributed earlier than on retirement, death, disability, separation from service, hardship, age 59½, or termination of the plan. Also, as with any qualified plan distribution, the 10 percent early withdrawal penalty applies. Amounts attributable to matching and profit-sharing contributions can generally be withdrawn according to the rules for profit-sharing plans discussed earlier.

The income taxation of distributions from 401(k) plans, including both 401(k) and non-401(k) amounts in the plan, follows the usual rules for qualified plan distributions. The qualified plan rules relating to loans and plan distributions.

Social Security and Employment Taxes

Section 401(k) plans are an exception to the general rule that contributions by an employer to a qualified plan are free of federal employment taxes (Social Security [FICA] and unemployment tax (FUTA)). The popularity of 401(k) plans when first introduced caused such a noticeable reduction in federal employment tax revenues that Congress made special rules for 401(k) plans. Under current law, 401(k) amounts subject to an employee election to defer instead of receiving cash (elective deferrals) are subject to FICA and FUTA, whether these are contributed through salary reduction or employer bonuses. FICA and FUTA do not apply to non-401(k) amounts—matching or profit-sharing contributions made by the employer to the plan that are not subject to elective deferrals.

In general, state unemployment compensation and workers' compensation payments are not required for either employer contributions or salary reductions in a 401(k) plan.


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