Over-50 Catch-Up Contributions

For those who will reach age 50 before the year’s end, the limit on the amount you may contribute to a 403(b), 401(k), or 457 account increases by $6,000. This boosts the individual contribution limit from $18,500 to $24,500. 

General Breakdown of 401(k)s, 403(b)s, and 457 Plans 
When it comes to comparing 401(k)s, 403(b)s, and 457 plans, there are many similarities and few differences. The similarities include: 

• $18,500 contribution limit (2018);
• $6,000 over-50 catch-up contribution; 
• Risk of investing falls on employee; 
• Withdrawals taxed as ordinary income; and 
• Amounts deferred on a pre-tax basis. 

 The major differences include: 

• 403(b)s and 457s have additional catch-up deferrals, as discussed above; 

• 401(k)s are open to most employers, 403(b)s are open to tax-exempt and non-profit organizations, and 457s are open to state/local governments and some non-profit organizations; and  
• 457 plans may not be subject to early withdrawal penalties like 403(b)s and 401(k)s. 

Mingling Contributions Among 401(k)s, 403(b)s, and 457 Plans

If you have a 401(k) and a 403(b), the maximum amount you can contribute to both accounts combined is $18,500 (2018). If you have a combination of a 401(k) and/or a 403(b) paired with a 457 plan, the maximum you can contribute combined is $37,000: $18,500 to the 401(k) and/or 403(b) and $18,500 to the 457. Plus, you can make any catch-up contributions allowed. The money you save into each account should be in order of employer matching with the employer plan that matches you at the highest rate first, until the match is completely maximized; then the money should flow to the account with the second-best matching and so on until you have contributed your overall maximum contribution to all plans. 

Potential Downsides for Company Stock in a 401(k)

All tax strategies can be useful, but it is generally not recommendable to let the “tax tail wag the dog.” Trying to pursue this NUA strategy too aggressively can lead to you owning too much company stock and not having your portfolio appropriately diversified. You only have a few different triggering events, which means you only have a few opportunities to distribute the stock, possibly leading to overzealous distributions in the year in which they can be made. This can lead to paying taxes at a higher-than-normal tax bracket and not leaving as much money as you would normally leave in your retirement account, ultimately leading to higher taxes in the long run because all the investments held outside your retirement account are taxed every year. Your heirs do not receive a “step up in basis” on NUA shares upon your passing. You may be charged a penalty for an early retirement account withdrawal if you retire earlier than 59.5 years old, (although in some cases you can take penalty-free distributions as early as age 55). You cannot strategically convert these assets into Roth IRA assets over the years at a potentially low tax rate if they are taken as NUA; however, any amounts rolled into an IRA and not taken as an NUA distribution can still be converted to a Roth IRA. You will have to pay any applicable state taxes on the NUA withdrawal, which may apply equally to ordinary income and capital gains.

Keep in Mind 

• You will have to pay gains (for any price changes in the stock subsequent to the distribution) on any shares distributed from the retirement account and not sold immediately as either short- or long-term gains. 

• It is generally wise to keep the NUA stock in an account separate from other company stock to simplify your recordkeeping.  

• In addition, note that the NUA is not subject to the 3.8% Medicare surtax on net investment income. 

• You are allowed to “cherry pick” which shares of stock to distribute in kind to the brokerage account and roll the remainder into an IRA. 

• Your heirs are allowed to take an NUA distribution when you pass away if the shares are still held in the company plan. 

• If you separate from service before the age of 59.5, have a very highly appreciated employer stock position, and you need to make a distribution from your retirement account, you would have to pay the normal 10% early withdrawal penalty. However, the penalty will be calculated off of your cost basis. This means if you purchased shares for $1,000 that are now worth $50,000, you can withdraw the $50,000 in employer stock and only pay the ordinary taxes and 10% penalty on the $1,000 cost basis. Then you would only have to pay taxes on the remaining $49,000 at your current capital gains tax rate. 

• You may be able to take an NUA distribution and then strategically sell the shares off in small amounts over the years to keep your income limited to a level that allows for 0% capital gains rates. 

• You can use the NUA distribution to satisfy your first required minimum distribution if you are over the age of 70.5 when you retire so you only have to pay ordinary income taxes on a potentially low-cost basis amount rather than the full amount of your first distribution when you would have had to distribute money from your retirement account anyway. This can significantly reduce the taxes due on your first required minimum distribution.

Company Stock in a 401(k): Net Unrealized Appreciation

Net Unrealized Appreciation (NUA) is the name of a little-known tax break that can help save you money on taxes from employer stock held in a 401(k) plan if you qualify. NUA rules allow you to take employer stock out of your 401(k) upon certain triggering events, only pay ordinary income taxes on the cost basis of the stock (the price you originally paid for the stock) for the withdrawal, and then have the gains taxed at capital gains tax rates. This can be particularly valuable if: 

• You have highly appreciated employer stock (stock with very low-cost basis);  
• You have an immediate need to withdraw money from your 401(k);  
• You are retiring after age 70.5 and you have to take your first required minimum distribution (RMD); or  
• You have a short RMD period, including stretch RMDs. 

The rules for an NUA distribution are very strict, and you should work with your CPA to make sure you follow all the rules precisely. The rules are as follows: 

• You have to distribute the entire balance of your 401(k) and any other qualified plans you have with the employer in a single tax year (some can be withdrawn directly to a taxable account and some can be rolled into an IRA, but there can be no money left in your 401(k) account at the end of the tax year).  
• You must take the distribution of company stock from your 401(k) in actual shares—you cannot sell the shares in the 401(k) and then distribute cash.  
• You must have experienced one of the following triggering events: 
• Separation from service from the company whose plan holds the stock (this may include certain cash buyouts of the company you work for);  
• Reached age 59.5; 
• Become disabled; or 
• Death 

Mega Backdoor Roth 401(k) contributions

By using the right strategies, you may be able to contribute more than you thought possible and, in turn, save more money on taxes over time. In general, employees can only contribute up to $18,500 per year to a retirement plan with an additional catch-up of up to $6,000 per year if the employee is 50 years old or older (“employee contribution limit”). Many employees don’t realize that the maximum contribution to one of these accounts is $55,000 per year plus the catch-up (“maximum contribution limit”)—and that they may be able to contribute up to that amount despite the employee contribution limit and employer matching amounts adding up to less than the full maximum contribution limit.

The strategy is as follows:

Normally, this would mean you could not fund your 401(k) up to the maximum contribution limit of $55,000, leaving a full $24,000 on the table ($55,000 – $31,000 = $24,000). If you have a nondeductible 401(k) and work for a company with retirement plan documents that allow it, however, you can make a $24,000 contribution to the nondeductible part of the 401(k) and then convert the contribution to the Roth portion of your 401(k). This effectively allows you to maximize the yearly contribution to your retirement account. 

A very highly compensated employee can still take advantage of this strategy because employers can only base 401(k) matching off $275,000 of an employee’s compensation per year no matter how highly compensated the individual is. A 401(k) can provide a versatile savings account by allowing penalty-free (but not tax-free) distributions of certain amounts for a down payment on a home purchase or medical expenses. Keep in mind that any additional profit-sharing plan contributions by the employer must be considered when calculating the overall yearly contribution. It is very important to check the plan documents and speak with your HR department or plan administrator to make sure you are getting the most from your retirement plan.

SIMPLEs | 401(k) and Other Salary Savings Plans

In an attempt to increase coverage of employer-sponsored plans, Congress has provided certain simplified arrangements that are not qualified plans but provide employers and employees some of the same benefits as qualified plans. One such arrangement, structured as a salary savings plan somewhat similar to a 401(k) plan, is the SIMPLEs (savings incentive match plans for employees). SIMPLEs are employer-sponsored plans under which plan contributions are made to the participating employees' IRA's. SIMPLEs also can be part of a 401(k) plan, but this arrangement is somewhat more complicated than a SIMPLE/IRA. Tax-deferred contribution levels are generally significantly higher than the $2,000/$4,000 deductible limit for individual IRAs. SIMPLEs feature employee salary reduction contributions (elective deferrals) coupled with employer matching contributions.

SIMPLEs are easy to adopt and generally simple to administer, while providing employees with the tax-deferred retirement savings benefits of a qualified plan. However, qualified plans potentially can provide higher contribution levels. An employee's salary reductions under a SIMPLE can be no greater than $6,000 annually.

Eligible Employers

Any employer may adopt a SIMPLE if it meets the following requirements:

• The employer has 100 or fewer employees.

• The employer does not maintain a qualified plan, 403(b) plan, or SEP except for a collectively bargained plan.

Advantages and Disadvantages

SIMPLEs can be adopted by completing a simple IRS form (Form 5304-SIMPLE or 5305-SIMPLE) rather than by the complex procedure required for qualified plans. Benefits of a SIMPLE/IRA are totally portable by employees because funding consists entirely of IRAs for each employee and employees are always 100 percent vested in their benefits. Employees own and control their accounts, even after they terminate employment with the original employer. Individual IRA accounts allow participants to benefit from good investment results, as well as run the risk of bad results. As with a 401(k) plan, a SIMPLE can be funded in part through salary reductions by employees.

However, SIMPLEs have some disadvantages. As with profit-sharing or salary savings plans in general, employees cannot rely on a SIMPLE to provide an adequate retirement benefit. First, benefits are not significant unless the employee makes significant regular salary reduction contributions. Such regular contributions are not a requirement of the plan. Furthermore, employees who enter the plan at older ages have only a limited number of years remaining prior to retirement to build up their SIMPLE accounts. Also, annual contributions generally are restricted to lesser amounts than would be available in a qualified plan. SIMPLE contributions are limited by the maximum $6,000 (as indexed; 2000: $6,000) salary reduction permitted for each participant (plus the employer's matching contribution). This contrasts with the $9,500 (as indexed; 2000: $10,500) annual salary reduction permitted for 401(k) or 403(b) plans. Distributions from SIMPLEs/IRAs are not eligible for the 5-year (or 10-year) averaging provisions available for certain qualified plan distributions. (Five-year averaging is repealed for years after 1999, but 10-year averaging is available even after 1999.)

Design Features of SIMPLEs

The following are the most significant Internal Revenue Code requirements for SIMPLEs (Section 408(p):

• The employer must have 100 or fewer employees (only employees with at least $5,000 in compensation for the prior year are counted) on any day in the year.

• The employer may not sponsor another qualified plan, 403(b) plan, or SEP under which service is accrued or contributions made for the same year the SIMPLE is in effect, except for a plan covering exclusively collective bargaining employees.

• Contributions may be made to each employee's IRA or to the employee's 401(k) account. In effect, there are thus two types of SIMPLEs—those that include the 401(k) requirements and those funded through IRAs. SIMPLEs meeting the 401(k) requirements are rarely adopted and will not be discussed further here.

• Employees who earned at least $5,000 from the employer in the preceding two years and are reasonably expected to earn at least $5,000 in the current year can contribute (through salary reductions) up to $6,000 (as indexed; 2000: $6,000) annually.

• The employer is required to make a contribution equal to either

  1. a dollar-for-dollar matching contribution up to 3 percent of the employee's contribution (the employer can elect a lower percentage, not less than 1 percent, in not more than two out of the past five years) or

  2. 2 percent of compensation for all eligible employees earning at least $5,000 (whether or not they elect salary reductions).

In a SIMPLE/IRA plan, each participating employee maintains an IRA. Employer contributions are made directly to the employee's IRA, as are any employee salary reduction contributions. Employer contributions and employee salary reductions, with the limits discussed above, are not included in the employee's taxable income.

Direct employer contributions to a SIMPLE are not subject to Social Security (FICA) or federal unemployment (FUTA) taxes. However, as with 401(k) plans, employee salary reduction contributions are subject to FICA and FUTA. The impact of state payroll taxes depends on the particular state's laws. Both salary reductions and employer contributions may be exempt from state payroll taxes in some states.

Distributions to employees from a SIMPLE/IRA plan are treated as distributions from an IRA. All the restrictions on IRA distributions apply and the distributions are taxed the same.

Installation of a SIMPLE

Installation of a SIMPLE can be very easy. The employer merely completes IRS Form 5304-SIMPLE or Form 5305-SIMPLE. Form 5305-SIMPLE provides for a "designated financial institution" for participant investments, while Form 5304-SIMPLE does not have this provision, which some plan sponsors and participants may find restrictive. Under a SIMPLE, salary reduction elections must be made by employees during a 60-day period prior to January 1 of the year for which the elections are made. The form does not have to be sent to the IRS or other government agency.

The reporting and disclosure requirements for SIMPLEs are simplified if the employer uses Form 5304-SIMPLE or 5305-SIMPLE. The annual report form (5500 series) need not be filed if these forms are used. In other cases, reporting and disclosure requirements are similar to those for a qualified profit-sharing plan.

SECTION 401(K) PLANS (CASH OR DEFERRED PLANS)

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.