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For several weeks now, our newsletters have introduced you to different pension plans available for employers and employees. Our journey is not even close to the end, yet. The subject of today’s newsletter is one of the better known pension plans, at least by name, the 401(k) plan.
The 401(k) plan was introduced in 1978 and has grown to become the most popular type of employer-sponsored retirement plan in America, mostly because of its relative flexibility. The plan got its name from its section number and paragraph in the Internal Revenue Code -- section 401, paragraph (k).
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A 401(k) plan is a qualified plan that includes a feature allowing an employee to elect to have the employer contribute a portion of the employee’s wages to an individual account under the plan. The underlying plan can be a profit-sharing, stock bonus, pre-ERISA money purchase pension, or a rural cooperative plan.
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.
A traditional 401(k) plan allows eligible employees to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both.
These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested.
Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.
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A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made.
These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals.
The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans. Safe harbor 401(k) plans that do not provide any additional contributions in a year are exempted from the top-heavy rules of section 416 of the Internal Revenue Code.
Both the traditional and safe harbor plans are for employers of any size and can be combined with other retirement plans.
The SIMPLE 401(k) plan was created so that small businesses could have an effective, cost-efficient way to offer retirement benefits to their employees.
A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans. As with a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested.
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This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.
The one-participant 401(k) plan is a traditional 401(k) plan covering a business owner with no employees, or that person and his or her spouse. These plans have the same rules and requirements as any other 401(k) plan. The business owner wears two hats in a 401(k) plan: employee and employer, so contributions can be made to the plan in both capacities.
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In general, an employee must be allowed to participate in a 401(k) plan if he or she meets both of the following requirements:
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- Has reached age 21, and
- Has at least 1 year of service.
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A 401(k) plan can have an automatic enrollment feature. This feature permits the employer to automatically reduce the employee’s wages by a fixed percentage or amount and contribute that amount to the 401(k) plan unless the employee has affirmatively chosen not to have his or her wages reduced or has chosen to have his or her wages reduced by a different percentage. These contributions qualify as elective deferrals.
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Two annual limits apply to contributions:
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- A limit on employee elective deferrals; and
- An overall limit on contributions to a participant’s plan account (including the total of all employer contributions, employee elective deferrals (but not catch- up contributions) and any forfeiture allocations).
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The limit on employee elective deferrals (for traditional and safe harbor plans) is $19,000 in 2019 ($18,500 in 2018).
The limit on employee elective deferrals to a SIMPLE 401(k) plan is $13,000 in 2019 ($12,500 in 2015- 2018).
If permitted by the 401(k) plan, participants who are age 50 or over at the end of the calendar year can also make catch-up contributions. The additional elective deferrals you may contribute is:
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All the amounts may be increased in future years for cost-of-living adjustments You don’t need to be “behind” in your plan contributions in order to be eligible to make these additional elective deferrals.
Generally, deferred wages contributions (elective deferrals) are not subject to federal income tax withholding at the time of deferral, and they are not reported as taxable income on the employee’s individual income tax return.
If the plan document permits, the employer can make matching contributions for an employee who contributes elective deferrals to the 401(k) plan. For example, a 401(k) plan might provide that the employer will contribute 50 cents for each dollar that participating employees choose to defer under the plan.
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The employer can make additional contributions (other than matching contributions) for participants, including participants who choose not to contribute elective deferrals to the 401(k) plan.
For 2019, no more than $280,000 of an employee’s compensation ($275,000 in 2018) can be taken into account when figuring contributions.
Generally, distributions of elective deferrals cannot be made until one of the following occurs:
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- The participant dies, becomes disabled, or otherwise has a severance from employment;
- The plan terminates and no successor defined contribution plan is established or maintained by the employer;
- The participant reaches age 591⁄2 or incurs a financial hardship.
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A 401(k) plan must provide that each participant will either receive his or her entire interest (benefits) in the plan by the required beginning date, or begin receiving regular periodic distributions by the required beginning date in annual amounts calculated to distribute the participant's entire benefits over his or her life expectancy or over the joint life expectancy of the participant and the designated beneficiary.
These required distribution rules apply individually to each qualified plan. The required distribution from a 401(k) plan cannot be satisfied by making a distribution from another plan. The plan document must provide that these rules override any inconsistent distribution options previously offered.
The required beginning date is April 1 of the first year after the later of the calendar year in which the participant reaches age 701⁄2, or the calendar year in which the participant retires.
A 401(k) plan may allow employees to receive a hardship distribution because of an immediate and heavy financial need (which is not capable of being relieved from other resources reasonably available to the employee).
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| If your employer permits it, you may be able to take a loan from your 401(k) plan. If this option is allowed, up to 50% of the vested balance can be borrowed up to a limit of $50,000. The loan must usually be repaid within five years. A longer repayment period is allowed for a primary home purchase. The interest rate that you pay to yourself will be comparable to the rate charged by lending institutions for similar loans. |
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If a distribution is made to a participant before he or she reaches age 591⁄2, the participant may be liable for a 10% additional tax on the distribution. This tax applies to the amount received that the employee must include in income.
This is only a summary of the numerous rules and regulations that apply to 401(k) plans and should be a very good argument for the need of professional advice in any decision that affects your financial wellbeing at retirement.
In the meantime, keep up with our newsletters to see what other kinds of pension plans are out there and for regular updates on topics of general interest.
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