401(k) Plan Fix-It Guide - 401(k) Plan - Overview
Generally, Internal Revenue Code Section 401(k) permits an employee to elect to have his/her employer contribute a portion of the employee’s wages to a 401(k) plan on a pre-tax basis (these employee contributions are known as elective deferrals, salary deferrals or salary reduction contributions). A 401(k) plan is also referred to as a cash or deferred arrangement, or CODA. A 401(k) plan may also include other types of employer and employee contributions.
Elective deferrals (other than designated Roth contributions) aren't subject to federal income tax withholding at the time of deferral and they aren't reflected as income on the employee’s Form 1040, U.S. Individual Income Tax Return.
Example: Jan earns $25,000 in a year and elects to defer $3,000 into a 401(k) plan. Jan will only include $22,000 as income on that year’s tax return.
Although the law doesn't treat amounts deferred as current income for federal income tax purposes, they are included as wages subject to Social Security (FICA), Medicare and federal unemployment taxes (FUTA). Additionally, elective deferrals are always 100% vested, or fully owned by the employee.
A 401(k) plan is a “qualified plan” - one that satisfies the requirements listed under Internal Revenue Code Section 401(a). If a plan satisfies these requirements, contributions made by the employer to the plan may be currently deductible and the contributions ordinarily won't be included in employees’ gross income until distributed from the plan. If a plan fails to satisfy any of the Section 401(a) requirements, the plan becomes “disqualified” and the favorable tax benefits associated with these plans may be lost.
There are several types of 401(k) plans available to employers:
- traditional 401(k) plans,
- safe harbor 401(k) plans, and
- SIMPLE 401(k) plans.
Different rules apply to each. The following is a brief description of each type of 401(k) plan:
Traditional 401(k) plans allow employees who have met the plan’s eligibility requirements to make pre-tax elective deferrals or designated Roth contributions to a 401(k) plan through payroll deductions (elective deferrals). In addition, employers have the option of contributing for all eligible employees matching contributions based on employees’ elective deferrals, other nonelective employer contributions or any combination of these contributions. These employer contributions can be subject to a vesting schedule, which provides that after a period of time an employee’s right to employer contributions becomes nonforfeitable, or they can be immediately vested. Rules relating to traditional 401(k) plans require that plan contributions meet specific nondiscrimination requirements. To ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the actual deferral percentage and actual contribution percentage tests, to verify that elective deferrals and employer matching contributions do not discriminate in favor of highly compensated employees.
Plan sponsors can increase participation in 401(k) plans by adding an automatic enrollment feature to a traditional 401(k) plan. An eligible automatic contribution arrangement allows a participant to withdraw automatic enrollment elective deferrals within 90 days of the first contribution made for the participant without incurring an additional 10% tax under IRC Section72(t). The EACA provides a participant with a window to reconsider automatic enrollment deferrals. Any withdrawn amounts aren't considered in the ADP test and any matching contributions forfeited because of the withdrawn amounts aren't considered in the ACP test. Another advantage of the EACA is that, as long as all eligible employees are covered by the EACA, excess contributions and excess aggregate contributions may be distributed within 6 months (instead of 2 ½ months for other 401(k) plans) after the end of the plan year and avoid the excise tax on excess contributions under IRC Section 4979.
Plans with the automatic enrollment feature must take steps to ensure that amounts are withheld in a timely manner. For a discussion on finding, fixing and avoiding this mistake, please see “ The Fix Is In: Correcting a Failure to Implement the Plan's Automatic Enrollment Provisions.”
Safe harbor 401(k) plans are similar to traditional 401(k) plans; however, if the plan meets the safe harbor requirements under IRC Section 401(k)12), the employer doesn't have to perform the annual ADP or ACP nondiscrimination tests that apply to traditional 401(k) plans. With the safe harbor option under IRC Section 401(k)(12), plan sponsors may choose one of two safe harbor designs, each with their own set of rules. The second option has an automatic contribution feature that satisfies the requirements under IRC Section 401(k)(13) and is referred to as a qualified automatic contribution arrangement (QACA).
The ADP test requirement is considered satisfied under both safe harbor options if:
- a prescribed level of safe harbor matching or nonelective contributions is made for all eligible nonhighly compensated employees, and
- employees are provided a timely notice describing their rights and obligations under the plan.
Matching contributions made to satisfy the ADP safe harbor requirement are also considered for satisfying the ACP test. Other matching contributions (not used for satisfying the ADP safe harbor) are generally subject to the ACP test unless the plan meets certain other requirements. The ADP safe harbor matching contribution requirements, however, are different for each of the safe harbor options. Both safe harbor options provide that, instead of the matching contribution, a plan can satisfy the ADP safe harbor requirement by making a nonelective contribution that is equal to at least 3% of compensation for each eligible nonhighly compensated employee.
The key areas where the two safe harbor options differ are:
1. Automatic enrollment feature: A plan designed to satisfy the safe harbor option under IRC Section 401(k)(12) is not required to provide for an automatic enrollment feature. On the other hand, a safe harbor option under IRC Section 401(k)(13), QACA, must provide for an automatic enrollment feature. Under that feature, unless employees affirmatively elect otherwise, they're treated as if they elected to have the employer make elective contributions equal to no less than:
- 3% of compensation for the initial period,
- 4% for the plan year following the initial period,
- 5% for the next plan year, and
- 6% for the years that follow.
An employer may set the automatic contribution amount at a percentage that is higher than the minimums, but no higher than 10% of compensation. The QACA notice provided to participants must explain the employee’s right to opt out and not have elective contributions made or elect to have the contributions made at a different percentage. The notice should also explain how the contributions will be invested in the absence of any specific investment direction by the employee.
2. ADP safe harbor matching contributions: Matching contributions made for an employee for satisfying the safe harbor requirement under IRC Section 401(k)(12) should, for each level of an employee’s deferral, be greater than or equal to the matching contribution under the following formula:
- 100% of elective contributions that do not exceed 3% of compensation, plus
- 50% of elective contributions between 3% and 5% of compensation.
In a QACA, the ADP safe harbor matching contribution made for an employee should, for each level of an employee’s deferral, be greater than or equal to the matching contribution under the following formula:
- 100% of elective contributions that do not exceed 1% of compensation, plus
- 50% of elective contributions between 1% and 6% of compensation.
3. Vesting of employer contributions made to satisfy the ADP safe harbor requirement: In a plan designed to satisfy the requirements of IRC Section 401(k)(12), employees must be fully vested in ADP safe harbor contributions made for them.
In a QACA, the plan could require that employees complete two years of vesting service before they can be vested in the ADP safe harbor contributions.
Employers sponsoring safe harbor 401(k) plans must also provide each eligible employee with written notice of the employee's rights and obligations under the plan and the notice must describe the safe harbor method used, how eligible employees make elections, and any other plans involved.
Generally, the employer must provide the notice within a reasonable period - between 30 and 90 days before the beginning of each plan year.
SIMPLE 401(k) plans are not subject to the annual ADP and ACP nondiscrimination tests that apply to traditional 401(k) plans. Similar to a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is only available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the prior calendar year. In addition, employees covered by a SIMPLE 401(k) plan may not receive contributions or benefit accruals under any other plans of the employer.