401k plans are defined contribution plans
Other defined contribution retirement savings plans include SEPs, Simple IRAs, Profit Sharing Plans and Money Purchase Plans. The 401k is by far the most popular.
Defined contribution plans differ from traditional pension plans, called defined benefit plans, which specify specific amounts of money (the "benefit") employees will receive when they retire rather than the periodic contribution amounts that will be put into the plan to ensure that final benefit amount.
In 401k plans...
The plan sponsor
401k plan sponsorship does not, however, mean the employer must contribute financially to its 401k plan. Please see below, for information on the contribution options - including the option not to contribute - open to plan sponsors.
The Internal Revenue Code allows for retirement savings plans that DO NOT require employer sponsorship; these include annuities and Individual Retirement Accounts (IRAs), but the 401k plan is by far the most popular:
Plan sponsorship generally entails the employer appointing an in-house person to act as liaison between the plan's vendors and the company's employees. This person is the plan administrator (not to be confused with the outside vendor, if any, providing the overall plan administration; in the case of self-service 401k plans such as 401k Easy, there is no such outside vendor).
The plan vendor
Often the vendor supplies 401k administration services, too. Sometimes the vendor even supplies its own lineup of 401k plan investments.
Automatic enrollment is also called "passive enrollment" and "negative enrollment"; the default contribution and investment designations are called the plan's "negative elections."
The IRS approved negative elections relatively recently; certain legalities outside of the scope of the IRS remain undefined, so prudence says to consult a legal advisor before adopting automatic enrollment for your 401k plan.
Employees cannot contribute more than 15% of their annual earnings to their 401k account. Additionally, they cannot contribute more than an annually-adjusted total dollar amount of their annual earnings to their 401k account.
Any employer qualified nonselective contributions are 100% vested to employees when made. Employer matching and profit sharing contributions, on the other hand, do not have to immediately become the property of the employees. Instead, employers can impose a vesting schedule by which the 401k participants gain full ownership of employer contributions incrementally, over time. For example...
401k contribution guidelines and limitations
401(k) Resource Guide - Plan Participants - Limitation on Elective Deferrals
There is a limit on the amount of elective deferrals that you can contribute to your traditional or safe harbor 401(k) plan.
Generally, all elective deferrals that you make to all plans in which you participate must be considered to determine if the dollar limits are exceeded.
Limits on the amount of elective deferrals that you can contribute to a SIMPLE 401(k) plan are different from those in a traditional or safe harbor 401(k).
Although, general rules for 401(k) plans provide for the dollar limit described above, that does not mean that you are entitled to defer that amount. Other limitations may come into play that would limit your elective deferrals to a lesser amount. For example, your plan document may provide a lower limit or the plan may need to further limit your elective deferrals in order to meet nondiscrimination requirements.
Catch-up contributions. For tax years beginning after 2001, a plan may permit participants who are age 50 or over at the end of the calendar year to make additional elective deferral contributions. These additional contributions (commonly referred to as catch-up contributions) are not subject to the general limits that apply to 401(k) plans. An employer is not required to provide for catch-up contributions in any of its plans. However, if your plan does allow catch-up contributions, it must allow all eligible participants to make the same election with respect to catch-up contributions.
If you participate in a traditional or safe harbor 401(k) plan and you are age 50 or older:
If you participate in a SIMPLE 401(k) plan and you are age 50 or older:
The catch-up contribution you can make for a year cannot exceed the lesser of the following amounts:
Participation in plans of unrelated employers. If you participate in plans of different employers, you can treat amounts as catch-up contributions regardless of whether the individual plans permit those contributions. In this case, it is up to you to monitor your deferrals to make sure that they do not exceed the applicable limits.
Example: If Joe Saver, who’s over 50, has only one employer and participates in that employer’s 401(k) plan, the plan would have to permit catch-up contributions before he could defer the maximum of $24,000 for 2015 (the $18,000 regular limit for 2015 plus the $6,000 catch-up limit for 2015). If the plan didn’t permit catch-up contributions, the most Joe could defer would be $18,000. However, if Joe participates in two 401(k) plans, each maintained by an unrelated employer, he can defer a total of $24,000 even if neither plan has catch-up provisions. Of course, Joe couldn’t defer more than $18,000 under either plan and he would be responsible for monitoring his own contributions.
The rules relating to catch-up contributions are complex and your limits may differ according to provisions in your specific plan. You should contact your plan administrator to find out whether your plan allows catch-up contributions and how the catch-up rules apply to you.
Treatment of excess deferrals. If the total of your elective deferrals is more than the limit, you can have the difference (called an excess deferral) returned to you from any of the plans that permit these distributions. You must notify the plan by April 15 of the following year of the amount to be paid from the plan. The plan must then pay you that amount plus allocable earnings by April 15 of the year following the year in which the excess occurred.
Excess withdrawn by April 15. If you withdraw the excess deferral for 2014 by April 15, 2015, it is includable in your gross income for 2014, but not for 2015. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.
Excess not withdrawn by April 15. If you do not take out the excess deferral by April 15, 2015, the excess, though taxable in 2014, is not included in your cost basis in figuring the taxable amount of any eventual distributions from the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.
Reporting corrective distributions on Form 1099-R. Corrective distributions of excess deferrals (including any earnings) are reported to you by the plan on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
Additional limits. There are other limits that restrict contributions made on your behalf. In addition to the limit on elective deferrals, annual contributions to all of your accounts - this includes elective deferrals, employee contributions, employer matching and discretionary contributions and allocations of forfeitures to your accounts - may not exceed the lesser of 100% of your compensation or $52,000. In addition, the amount of your compensation that can be taken into account when determining employer and employee contributions is limited. In 2014, the compensation limitation is $260,000; for 2015, the limit is $265,000
Every 401k plan must offer a minimum spectrum of investments, as defined in the Internal Revenue Code.
With 401k Easy you have an unlimited selection of 401k investments. Please visit our Investments page for examples and details.
401k investing and tax-deferred saving
Withdrawals and 401k loans
Outside of these instances, there are only two ways for participants to withdrawal money from a 401k account while employed: hardship withdrawal and 401k loan.
To view in a secondary window a chart briefly comparing hardship withdrawals with 401k loans, click here.
401k loans are not discharged in bankruptcy (the participant's bankruptcy). Also, it is permissible for an employer or court to ensure repayment of such loans through payroll withholding.
Hardship withdrawals and 401k loans can increase a plan's popularity even if participants never take advantage of the features, because employees don't feel participation means sending their money into some seemingly never-to-be-seen-again abyss. Retirement, after all, may be decades away.
ERISA participant rights protections
ERISA sets standards for, among other things...
ERISA aims to ensure that retirement monies actually exist at employees' retirements by preventing fund mismanagement by administrators, trustees and others. An employer interested in purchasing an ERISA bond for the company's 401k typically buys a bond that covers 10% of the plan's total assets. ERISA bonds are very economical and easy to buy. Most insurance agents offer these bond's to small companies at very low annual rates.
Fiduciary Liability Insurance - Fiduciary liability insurance is different than an ERISA bond. Fiduciary liability insurance is a completely discretionary purchase on the part of the employer; it provides broad coverage for all persons who are de facto "fiduciaries" of the company's plan. A fiduciary is someone who provides investment advice to the plan for a fee, and/or has discretionary control or authority over the administration of the plan, and/or who has authority or control over plan assets. (note: NASD Registered Representatives are not considered fiduciaries; they earn commissions on plan assets and typically do not charge fees for investment advice.)
Fiduciary liability insurance is very inexpensive; the cost is approximately five 5 percent of the coverage limits purchased, unless the company offers its own stock as an investment option, which increases the premium. Coverage is broad, and the only exclusions are for deceptive practices and fraud, which is covered by the ERISA bond. Providers of fiduciary liability insurance coverage include American International Group (AIG); Chubb Executive Risk; Lloyd's of London; Reliance Insurance; and Travelers Property Casualty.
IRS compliance testing
Not correcting a failed year-end compliance test can mean substantial penalties and possibly even disqualification of the plan's tax-exempt status. Test failures can be VERY expensive in terms of IRS penalty fees, man-hours spent trying to correct the problems and lost rapport with your employees, who may have to amend and refile their income tax forms -- and often pay additional income taxes, too.
The most common compliance tests are the ADP test, ACP test, and top-heavy test.
Safe Harbor 401k Plan Administration
The IRS offers an alternative means of achieving 401k plan balance: The safe harbor method of plan operation lets 401k plans skip their annual 401k discrimination testing so long as the sponsoring employer meets certain employer 401k contribution requirements designed to ensure broad participation in the company plan and provides 100% immediate vesting of the contributions.
The employer must provide annual information to employees explaining the 401k plan's safe harbor provisions and benefits, including that safe harbor contributions can not be distributed before termination of employment and that they are not eligible for financial hardship withdrawal.
Employers can decide as late as 30 days before the end of each plan year whether or not to take the safe harbor route. However, if, as its safe harbor contribution, the employer wants to make matching contributions rather than the flat 3% of compensation contribution, the employer must define the matching formula well ahead of those 30 days; in fact, any safe harbor matching contribution must be defined and communicated to employees no later than 30 days before the START of the applicable plan year so employees have plenty of time to adjust their contribution rates accordingly.
Your 401k Easy system includes such notification within your customized 401k plan's Summary Plan Description, a document that's updated at least annually for all eligible employees.
Economic growth and tax reconciliation act of 2001 (EGTRA)
401k-type plans for one-person businesses
The 401k plan's popularity lies in that it enables people to shelter a significant portion of their income from current income taxes. In some cases, a 401k plan enables a person to shelter more than twice as much as do other qualified retirement plans (money purchase pension plans, simplified employee pension (SEP) plans and savings incentive match plans for employees (SIMPLEs), more specifically). Until recently, however, a 401k plan needed multiple plan participants. It was not an option for one-person companies and the like - again, that is, until 2002. The one-person 401k plan is now a reality.
An estimated 18 million one-person business owners are eligible to participate in one-person 401k plans. Eligible businesses include corporations, sole proprietorships and non-profit organizations. From the accountant to the lawyer, doctor, software programmer and real estate agent, among others, who hangs his or her own shingle, the one-person 401k is now a possibility.
One-person 401ks are designed for owner-only businesses (including spouse) and businesses with employees who can legally be excluded from participation using federal plan coverage requirements.
The One-Person 401k's Advantages Over SEP IRAs and SIMPLE IRAs
One-Person 401k plans can be used for incorporated and unincorporated businesses, including C corporations, S Corporations, single member LLCs, partnerships and sole proprietorships. Real estate brokers, consultants, attorneys, manufacturers representatives, interior designers, retirees starting a new business and other professionals who work by themselves are prime candidates.
Under rules created by changes in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that became effective in January 2002, a business consisting of only an owner or an owner and his or her spouse, can make greater tax-deductible contributions in a one-person 401k than under a SEP-IRA or SIMPLE IRA. Contributions are discretionary, so owners can vary them from year to year or skip them altogether.
Total tax-deferred contributions to a one-person 401k cannot exceed 100% of pay, up to a maximum of $41,000 for people younger than age 50. This amount includes salary deferrals of up to $13,000 ($16,000 if age 50 or older) plus an employer contribution of up to 25% of pay (20% for self-employed). While SEP-IRA contributions also max out at $41,000, they are limited to 25% of pay (20% for self-employed). And, SEP-IRAs do not provide for additional catch-up contributions. With a SIMPLE IRA, employees under age 50 can defer up to $9,000 this year, while those age 50 or older can contribute up to $10,500. The employer can make additional required contributions.
Under these guidelines, a business owner under age 50 with earned income of $100,000 who is the sole employee of his business could contribute a maximum of $25,000 to a SEP-IRA, $12,000 to a SIMPLE IRA, and $38,000 to a one-person 401k (consisting of a $13,000 salary deferral plus an employer contribution of $25,000). Someone with $150,000 in W-2 income could contribute as much as $37,500 to the SEP-IRA, $13,500 to the SIMPLE IRA, and $41,000 to the one-person 401k.
The ability to make generous contributions at lower income levels means that business owners who want to catch-up on retirement contributions can do so more quickly than they could with a SEP-IRA or a SIMPLE IRA. Someone in his 50s with $100,000 in income could put away $41,000 for retirement this year with a one-person 401k; that amount of tax-deferral is not possible with a SEP or SIMPLE IRAs.
Retirement plan experts say that investment flexibility, and possible increased protection of personal assets from litigation, in addition to higher contribution levels, are additional the major draws of one-person 401k plans. The plans can accept rollovers from virtually any type of retirement plan, including a corporate 401k or an IRA. Business owners can also borrow the lesser of 50% of the plan balance, or $50,000. Loans are not allowed from SEP and SIMPLE IRAs, or IRA Rollovers.
The one-person 401k loan feature is a powerful advantage for business owners who may need quick, short-term access to their money without incurring the taxes and penalties associated with taking an early distribution from a rollover IRA. A lot of people are using a one-person 401k to consolidate existing retirement accounts, then borrow against the plan.
For someone under age 59 ½ who has left a job and is strapped for cash, the loan feature can be a way to get money out of a 401k without facing the penalties and taxes associated with a premature retirement plan distribution. The only requirement to establish an account is that you have self-employment income; a person between jobs and doing consulting work would qualify. Loans must be repaid according to IRS guidelines, as they would with a corporate 401k, or they become subject to taxes and penalties.
When considering establishing a one-person 401k, look for:
401k retirement plans are excluded from bankruptcy estates
The Act provides a limited exemption of $1,000,000 to traditional and Roth IRAs. The debtor may petition the bankruptcy court for protection beyond that limit, and the court may grant the relief "if the interest of justice so requires." The benefits in IRA-based retirement plans, such as simplified employee pension plans (SEPs) or simple retirement accounts (SIMPLEs), are fully protected (the dollar limit does not apply to those plans).
As a practical matter, IRA holders often commingle rollover and traditional contributions in a single IRA. Under the Act, rollover contributions have unlimited protection if they came from tax-exempt funds. For this reason, IRA holders should account separately for those funds. The most prudent approach may be to put them in a separate IRA.
It should be noted that the Act clarifies that participant loans are not discharged in bankruptcy if they are owed to a pension, profit-sharing, stock bonus or other tax-exempt deferred compensation arrangement. And, it is permissible to ensure repayment of such loans through payroll withholding.
The Act is significant because it excludes from the bankruptcy estate a much broader range of tax-exempt retirement arrangements than prior law. The Act, too, provides specific federal authority for exempting IRAs from bankruptcy estates. Historically, IRAs were thought to be subject to the claims of bankruptcy creditors - at least under federal law (many states had given full or partial protection to IRAs). More recently, the U.S. Supreme Court held that there was limited protection for IRA benefits.
Overall, the new law affords greater asset protection of particularly beneficial to corporate officers, directors and other higher-compensated individuals. The Act became effective October 17, 2005, and does not apply to any bankruptcy cases filed prior to that effective date. Its protections apply only if the participant has filed for bankruptcy.
For sample Summary Annual Reports, including ready-to-complete PDFs, please see our 401k FedForms web site.