401k Planning for the future
Jimmy Francis
??Sense-Making, Certainty and Dealing with Complexity??Problem Solver ??? Employee Benefits Specialist at AssuredPartners. ??? Mayor South St. Paul, Minnesota??
401(k) Plans
A 401(k) plan?permits employees to set aside a portion of their compensation through payroll deduction for retirement savings.?
401(k) plans are so named because they are designed to meet certain requirements of § 401(k) of the Internal Revenue Code. Under a 401(k) plan, a participant may elect to make pre-tax salary reduction contributions—also called deferrals—to the plan. For example, the employee might elect to contribute 3 percent of their pay to the plan. The employer deducts that amount from the payroll and contributes it to the participant’s account. The employee’s elective deferral contributions are not treated as current income for federal income tax purposes, and enjoy tax deferral until distribution. (Designated Roth contributions, on the other hand, are included in the employee’s ordinary income for tax purposes.)?
Typically, as an inducement for employees to make salary reduction contributions, an employer will design a 401(k) plan to also provide for employer matching contributions. Matching contributions are employer contributions based on the amount of a participant’s salary reduction contributions. For example, a typical employer matching contribution might be 50 percent of the first 6 percent of pay contributed by a participant. Employer contributions are not included in the employee’s taxable income. Also, employer contributions are deductible as business expenses on the employer’s federal income tax return.
Types of 401(k) Plans
There are several types of 401(k) plans available to employers, including:
Different rules apply to each type of plan. For tax-favored status, a plan must be operated in accordance with the applicable rules. Therefore, it is important that the employer be familiar with the rules that apply to its particular plan so the plan is administered in accordance with those rules.
The traditional, safe harbor, and automatic enrollment plans are for employers of any size.
Traditional 401(k) Plans
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 contributing a percentage of each employee’s compensation for allocation to the employee’s account (called a nonelective contribution), or matching the amount the employees decide to contribute, or both.
For example, an employer may decide to add a percentage, such as 50 percent, to an employee’s contribution, which results in a 50-cent increase for every dollar the employee sets aside. Using a matching contribution formula will provide additional employer contributions only to employees who make deferrals to the 401(k) plan. If an employer chooses to make nonelective contributions, the employer makes a contribution for each eligible participant, whether or not the participant decides to make a salary deferral to their 401(k) plan account.
Under a traditional 401(k) plan, employers have the flexibility of changing the amount of nonelective contributions each year, according to business conditions.
Vesting
Employee salary deferrals are immediately 100 percent vested, meaning the money that an employee has put aside through salary deferrals cannot be forfeited. When an employee leaves employment, the employee is entitled to those deferrals, plus any investment gains, or minus any losses on their deferrals.
In traditional 401(k) plans, employer contributions can be subject to a vesting schedule specifying that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or they may be immediately vested. For example, a plan may require that the employee complete two years of service for a 20 percent vested interest in employer contributions and additional years of service for increases in the vested percentage.
Nondiscrimination
To preserve the tax benefits of a 401(k) plan, the plan must provide substantive benefits for rank-and-file employees, not just business owners and managers. These requirements are called nondiscrimination rules and compare both plan participation and contributions of rank-and-file employees to owners/managers.
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 that the amount of contributions made on behalf of rank-and-file employees is proportional to contributions made on behalf of highly compensated employees.
Designated Roth Contribution Option
A 401(k) plan may permit an employee to irrevocably designate some or all of the employee’s deferrals under the plan as designated Roth contributions.?Designated Roth contributions?are salary deferrals that, unlike pre-tax elective deferrals, are currently includible in gross income. Such deferrals are subject to all applicable wage-withholding requirements at the time they are earned. Earnings are tax-deferred and tax-free upon withdrawal if certain requirements are met.
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Safe Harbor 401(k) Plans
There are several kinds of 401(k) plans that are not subject to the annual benefits testing required with traditional 401(k) plans. These are known as safe harbor 401(k) plans and, in exchange for avoiding the annual testing, employees in these plans must receive a certain level of employer contributions. Such contributions by the employer are fully vested when made. Employers must meet content and timing requirements in providing employees with notices concerning safe harbor 401(k) plans.
Mandatory Employer Contributions
The safe harbor 401(k) plan mandatory contributions requirement may be met by 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.
Each year the employer must make either the matching contributions or the nonelective contributions. The plan document will specify which contributions will be made, and this information must be provided to employees before the beginning of each year.
Vesting
Under the most popular safe harbor 401(k) plan, mandatory employer contributions must be fully vested when made. Such plans avoid the requirement to perform benefits testing that may result in returning contributions to highly compensated members as taxable income. If such plans avoid offering employer contributions beyond the ones mentioned above, they can be exempted from the top-heavy rules of IRC § 416.
Automatic Enrollment 401(k) Plans
A 401(k) plan can have an automatic enrollment feature. This feature allows an employer to automatically enroll all new employees who meet the eligibility requirements in the 401(k) plan, and reduce employee’s wages, at a predetermined fixed percentage or amount, unless the employee has been given an opt-out or “negative election” form and has affirmatively chosen not to have their wages reduced or has chosen to have their wages reduced by a different percentage.
These contributions qualify as elective deferrals. A default deferral amount is applied if members do not affirmatively elect a different level of contribution. Additionally, a default investment must be specified in case the employee fails to make such an election. This automatic process option has may act to reduce the percentage of eligible employees not participating, thereby increasing participation in 401(k) plans.
A basic automatic enrollment 401(k) plan must state that employees will be automatically enrolled in the plan unless they elect otherwise and must specify the percentage of an employee’s wages that will be automatically deducted from each paycheck for contribution to the plan. The document must also explain that employees have the right to elect not to have salary deferrals withheld or to elect a different percentage to be withheld.
SIMPLE 401(k) 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.
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. Such an employer cannot provide any other retirement plan for employees.?
A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans.
Under a SIMPLE 401(k) plan, the employer must make either of the following contributions:
The employees are totally vested in all contributions.
ERISA
The Employee Retirement Income Security Act of 1974 (ERISA) requires the employer and other employee benefit plan fiduciaries to act solely in the interest of, and for the exclusive benefit of, plan participants and beneficiaries. ERISA also imposes numerous requirements on plans and plan administrators, including reporting and disclosure requirements. The plan sponsor (employer) also has a duty to exercise care in selecting service providers and monitoring their services.
ERISA is regulated and enforced by the U.S. Department of Labor which provides this helpful guide to employers on?Meeting Your Fiduciary Responsibilities. Also helpful is the DOL’s?Reporting and Disclosure Guide for Employee Benefit Plans.
Employers considering a 401(k) plan, or any type of pension or retirement savings plan, are encouraged to work with legal counsel, financial advisors, and brokers that offer expertise in these matters. For more help like this See Jimmy Francis 651-321-8348
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