Lecture 25
401(k) and Other Tax Deductible
Salary Savings Plans
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Tax treatment
Illustration of the tax deferral advantage
Basic characteristics of 401(k) plans
Actual Deferral Percentage test
SIMPLE/IRAs
403(b) plans
457 plans
Tax Treatment
• Employees elect whether to participate and
how much to contribute to the plan
• Employee contributions reduce taxable
income for income tax purposes, but not for
Social Security taxes
• Investment income is not currently taxable
• Employee is taxed when the funds are
withdrawn from the plan
• Some plan withdrawals are eligible for
income averaging
Illustration of the Tax Deferral
Advantage
Assumptions:
$2000 per year in contributions for 40 years
Tax rates:
28% while working
15% after retirement
Interest rate: 8% (5.76% after-tax)
Annuity rate: $9.50 per $1 annual income
Calculations:
401(k):
$2000 per year at 8%
Other:
$1440 per year at 5.76%
Illustration of the Tax Deferral
Advantage (cont.)
Accumulations*:
401(k)
$559,562
Other
$221,941
Annual retirement income:
401(k)
$50,066 (559,626/9.5)x.85
Other
$23,362 (221,941/9.5)
*Annuity due factor: [(1+i)n+1 - (1+i)]/ i
For n = 40 and i = .08:
279.781
For n = 40 and i = .0576:
154.126
Basic Characteristics of 401(k)
Plans
• Private employers
• Maximum contribution:
– 15% of compensation subject to $9500
(indexed) maximum
• Voluntary participation
• Matching contributions allowed
• Vesting
– Employee contributions: immediate
– Employer contributions: standard rules
• Distribution restrictions
Actual Deferral Percentage Tests
A qualified 401(k) plan must meet one of the
following two tests:
1 ADP for HCE must not be more than 125%
of the ADP for non-HCE
2 ADP for HCE must not exceed the lesser of:
a) 200% of the ADP for non-HCE
b) ADP for non-HCE + 2%
ADP Test Example
• 10 employees in company
• A and B earn $100,000 per year (HCEs)
– A contributes 10%
– B contributes 6%
– ADP of HCE = 8%
• other 8 are non-HCEs
– 4 of non-HCE contribute 6%
– other 4 do not participate
– ADP of non-HCE = 3%
• Plan fails, since ADP of HCE cannot exceed:
– Test 1:
– Test 2:
a)
b)
3.75%
Lesser of
6%
5%
Designing a Plan to Meet the
ADP Tests
• Mandatory deferral
• Limiting the deferral by the HCE
• Encouraging non-HCE to participate
SIMPLE/IRAs
(Savings Incentive Math Plans for
Employers)
• Eligibilty
– Fewer than 100 employees
– No qualified plan
• Employer contributes to employees’ IRA
– Employees contribute up to $6,000 to IRA
– Employer matching contributions
• Advantages
– Simple
– Portable
• Disadvantages
– Benefits may not be adequate
– Lower limits than 401(k)
403(b) Tax-Deferred Annuity Plans
• Similar to 401(k) plans
• Eligible employers
– Tax exempt under section 501(c)(3)
– Educational organization
• Limits on contributions
– 403(b) Annual exclusion allowance
• 20% of compensation multiplied by
• Total years of service minus
• Amounts contributed in prior years
– 415 annual additions limit and catch-up
• 25% of compensation or $30,000
– Salary reduction limitation
• $9,500
– Salary reduction catch-up (if 15 years of service)
Section 457 Plans
• Similar to 401(k) plans
• Eligible employers
– Government
• Limitations
– Lessor of:
• $7500 (indexed) or
• 1/3rd compensation