401k plan administration can be a challenge. The regulations require diligent attention and the fiduciary responsibility is not to be taken lightly. That said, having a basic grasp of what is required of plan administrators can help allay some fears.
401(k) Plan Basics:
Section 401(k) provides for cash or deferred arrangements (CODA) through pre-tax employee deferrals into certain defined contribution plans. Technically 401(k) plans can not be stand alone. They must be part of another qualified plan. Defined contribution plans that are permitted to offer 401(k) provisions are SEP (SARSEP), profit sharing plans, stock bonus plans, ESOPs, pre-ERISA money purchase plans, and savings plans. Per SBJPA 96, salary reduction SEPs (SARSEPs) cannot be established after 1996. However, plans that were established prior to December 31, 1996, can continue.
Organizations that are permitted to offer plans with 401(k) provisions are:
1. For-profit incorporated or unincorporated businesses; and
2. Non-governmental tax-exempt organizations (Governmental units generally are not permitted to offer 401(k) plans; however, if the plan existed before mid-1986, it may continue)
The maximum employee elective deferral amount is the lesser of 100% of compensation or the
elective deferral limit for the year.
The elective deferral limits are as follows:
Year 401(k) Elective Limit Age 50+ catch-up
2004 $13,000 $3,000
2005 $14,000 $4,000
2006 $15,000 $5,000
The employer usually may match employee contributions. As with all defined contribution plans the annual limit on employer deductions is 25% of compensation of covered employees. Elective deferred amounts are not considered part of employer contributions.
Basic provisions of 401(k) elective deferrals:
-Usually done via payroll deduction
-Contribution made with before-tax dollars but are subject to FICA and FUTA taxes
-Usually some percentage of salary, within a given range up to the $15,000 limit this year
-Always 100% vested
401(k) Plan Information
Non-discrimination requirements for 401(k)'s
In addition to all the requirements of qualified plans, 401(k) plans are subject to unique non-discrimination testing.
Namely if the plan contains employee pre-tax elective contributions, the Average Deferral Percentage (ADP) test must be performed. The ADP test is unique to 401(k) plans only.
If the average deferral % for ALL eligible NHCE (Non-highly compensated employees) is:
A. Below 2%
B. Between 2% -8%
C. Over 8%
Then the max. average deferral % for ALL eligible HCE (highly compensated employees)
A. NHCE % x 2
B. NHCE % + 2%
C. NHCE % x 1.25
If the plan contains employee after-tax contributions and/or employer contributions, a similar test called the Actual Contribution Percentage (ACP) test must be performed.
*If avg. deferral % for all NHCE is 1.5%
then the avg. deferral percentage for all HCE can't exceed 3%
*If avg. deferral % for all NHCE is 3%
then the avg. deferral percentage for all HCE can't exceed 5%
*If avg. deferral % for all NHCE is 8%
then the avg. deferral percentage for all HCE can't exceed 10%
*If avg. deferral % for all NHCE is 10%
then the avg. deferral percentage for all HCE can't exceed 12.5%
When a 401(k) plan does not pass the ADP test, three fixes are available:
1. Distribute the excess contributions and associated earnings back to highly compensated employees;
2. Re-characterize excess employee contributions as distributions to employees that were then contributed after-tax to the plan, or
3. The employer to make nonforfeitable contributions to the nonhighly compensated employees accounts (but this is rarely done).
If either method 1 or 2 is used, the highly compensated employees will be subject to tax on the excess amounts.
The Annual Additions Limitation (the 415(c) Limitation )
Section 415(c) limits on the total amount of annual additions to a defined contribution plan
participant s account. This is the total amount of money that can be credited to a participant s
account during a calendar year form all the components that make the annual additions. Annual
additions are comprised of three components:
1. Employer contributions;
2. Employee contributions (deductible and nondeductible); and
3. Reallocated forfeitures.
Note that investment earnings are not part of the annual additions. The limit on maximum annual additions for a participant's account is the lesser of $44,000 (2006) or 100% of compensation. If a defined contribution plan exceeds the annual additions limit, it will lose qualified status (i.e. contribution deductibility) for the current year and succeeding years until the excess is corrected.
The Employer Deduction Limit
Plans must be established by December 31st of the year for which the employer will be contributing to the plan. However, contributions can be made to the plan as late as the due date of the company's tax return (including extensions). The deduction limit for all defined contribution plans is: 25% of covered payroll NOT reduced by employee elective deferrals. Deferrals, if any, are deducted separately and are not affected by this limit. Covered payroll is considered the compensation of all eligible employees. Excess employer contributions can be withdrawn or carried-forward to be deducted in succeeding years; otherwise, these nondeductible excess contribution amounts are subject to 10% excise tax.
If an employer's covered payroll is $1,000,000 then the maximum employer deduction is $250,000.
Q: If employee elective deferrals to a profit sharing plan amount to 8% of covered payroll, what amount can
the employer contribute and deduct to the plan?
A: Employer deduction = 25% of covered payroll. Employee elective deferrals do not reduce the amount
that the employer can deduct.
The Maximum Compensation Limit
Defined contribution plans can consider only $220,000 (in 2006) in compensation for the purposes of
making plan contributions.
ABC has a 15% money purchase plan. What is the contribution amount for each of the following?
John who makes $50,000 Contribution = $50,000 x 0.15 = $7,500
Bob who makes $100,000 Contribution = $100,000 x 0.15 = $10,000
Beth who makes $250,000 Contribution = $220,000 x 0.15 = $33,000 (only $220,000 considered)
401k Plans and Employer Stock
ERISA generally limits a qualified plan s acquisition or holding of qualifying employer securities to a maximum of 10%. However, certain plans are exempt from this limit. "Eligible individual account plans" are exempt profit sharing, stock bonus, thrift, or savings plans; employee stock ownership plans (ESOP). Thus, profit sharing plans can invest 100% of the plan's assets into the employer's securities, although that is rarely done.