Generally, Internal Revenue Code (IRC) Section 401(k) permits an employee to elect to have the 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 on a pre-tax basis 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, plan contributions made by the employer may be currently deductible and these 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've met the plan eligibility requirements to make pre-tax elective deferrals or designated Roth contributions through payroll deductions (elective deferrals). Additionally, 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, called the actual deferral percentage (ADP) and actual contribution percentage (ACP) tests, to verify that elective deferrals and employer matching contributions don't discriminate in favor of highly compensated employees. In addition, separate nondiscrimination testing under IRC Section 401(a)(4) may be required for non-elective employer contributions to the plan.
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 (EACA) 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 amounts withdrawn 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, 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, see the 401(k) Fix-it Guide for failures to correctly determine elective deferrals.
Safe harbor 401(k) plans are similar to traditional 401(k) plans; however, if the plan meets the safe harbor requirements under either IRC Section 401(k)(12) or IRC Section 401(k)(13), the employer doesn't have to perform the annual ADP or ACP nondiscrimination tests that apply to traditional 401(k) plans. Safe harbor plans have specific employer contribution (match or nonelective) , notice and vesting requirements. Safe harbor plans under IRC Section 401(k)(12) may or may not have an automatic enrollment feature. They are often referred to as traditional safe harbor 401(k) plans. Safe harbor plans under IRC Section 401(k)(13) must have an automatic enrollment feature. These plans are referred to as a qualified automatic contribution arrangement (QACA).
In general, the characteristics of traditional safe harbor 401(k) plans and QACAs can be found in the following chart.
|Characteristics||Traditional safe harbor Section 401(k) plan (IRC Section 401(k)(12)).||Qualified Automatic Contribution Arrangement (QACA) (IRC Section 401(k)(13).|
Option 1: Non-elective contribution equal to 3% of compensation on behalf of each non-highly compensated employee (NHCE).
Option 2: Matching contribution for each NHCE equal to:
Option 3: Enhanced matching contribution if:
Note: 1 and 2 required for plan to be exempt from ADP testing; 3 and 4 required in addition for plan to be exempt from ACP testing.
Option 1: same as option 1 under traditional safe harbor plan
Option 2: Matching contribution for each NHCE equal to:
Option 3: Enhanced matching contribution. – Same criteria as traditional safe harbor 401(k) plan except that the matching contribution must be at least as favorable as the match in Option 2 above (instead of Option 2 for traditional safe harbor 401(k) plan).
|Vesting of Employer Contributions||Participant is fully vested.||Plan may require completion of two years of vesting service before a participant is fully vested in employer contributions.|
|Automatic Deferrals||Optional. No statutory requirement.||
(To avoid the administrative burden of implementing an escalation feature as outlined above, plans could for example, set the default percentage at 6% of compensation for all plan years).
|Participant’s ability to opt out of automatic enrollment||Yes, if plan has an automatic enrollment feature. Not applicable, if the plan does not have an automatic enrollment feature.||Automatic enrollment is a mandatory feature of this plan. Participant should have the ability to have no amounts deferred or make an election to have a different amount deferred.|
Notice must be provided within a reasonable period before the beginning of the plan year (or in the year in which the employee first becomes eligible, within a reasonable period before the employee becomes eligible) that informs each employee of his or her rights and obligations under the plan (e.g. amount of safe harbor match or non-elective contribution, requirements for making deferral elections, compensation that may be deferred, withdrawal and vesting provisions that apply to the plan). A period that is at least 30 days but no more than 90 days before the beginning of the plan year is considered to be reasonable. In the case of an employee who becomes eligible after 90 days before the beginning of the plan year, a period that is no more than 90 days before an employee becomes eligible and no later than the date the employee becomes eligible is considered to be reasonable.
Note: For plan years beginning after December 31, 2019, the SECURE Act eliminates the notice requirement for non-elective 401(k) safe harbor plans.
Similar requirement as the requirement for traditional safe harbor 401(k) plans. However, notice also has to provide information that is unique to the QACA’s automatic enrollment feature. This includes:
|Requirement that plan provisions remain in effect for a 12-month plan year; mid-year amendments.||
Generally, plan provisions that satisfy the safe harbor plan rules should be adopted before the first day of the plan year and remain in effect for an entire 12-month plan year. However, under certain circumstances, it may be possible to adopt an amendment and make changes to the safe harbor plan during the plan year (mid- year plan amendments). See Notice 2016–16.
Note: The SECURE Act provides that an employer may amend a 401(k) plan to become a non- elective safe harbor plan at any time before the 30th day of the end of the plan year. If the non-elective contribution is at least 4% of compensation the amendment can be made up until the end of the following plan year.
|Generally, plan provisions that satisfy the QACA rules should be adopted before the first day of the plan year and remain in effect for an entire 12-month plan year. However, under certain circumstances, it may be possible to adopt an amendment and make changes to the safe harbor plan during the plan year (mid- year plan amendments). See Notice 2016–16.|
SIMPLE 401(k) plans aren't 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.