Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
What is it?
qualified profit sharing or stock bonus plan that gives
plan participants option to
put money in plan – tax deferred
receive same amount in cash – taxable
often called “cash or deferred arrangement” or CODA
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
When is it indicated?
1. employer wants qualified plan but can only afford
minimal costs
2. employer willing to meet minimal funding
requirement for non-HCEs and wants to maximize
contributions for HCEs without annual ADP tests
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
When is it indicated?
3. employee group
a. would like choice regarding saving level
b. young
c. willing to accept risk
4. employer wants ‘savings type’ plan to supplement
defined benefit plan
5. employer is private tax-paying or tax exempt
organization
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Advantages
1. tax-deferred savings for employees
2. gives employees some choice in amount to save
3. employer may contribute and deduct up to 25% of
payroll for covered employees in addition to elective
deferrals
4. can fund via employee salary reductions
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Advantages
5. some plan distributions may be eligible for special
10 year averaging on lump-sum distributions
6. in-service withdrawals for certain “hardships” may be
permitted
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Disadvantages
1. account balance at retirement may be inadequate
2. annual employee salary reduction limited to $16,500
(2009); over-50 also given ‘catch-up’ provisions of
$5,500 (2009)
3. costly and complex to administer
4. employees bear investment risk
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Salary Reductions
• can use salary reduction OR give employees “bonus”
that they can receive in cash or contribute to plan
• can use automatic enrollment
• employees MUST elect salary reduction BEFORE
salary earned
-
usually complete election form before end of each calendar year
-
can reduce or withdraw election on amounts not yet earned
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Salary Reductions
• participant always 100% vested in salary reduction
and plan earnings on those reductions
• account balance usually distributed as lump sum at
retirement
• plan faces ‘per employee’ elective deferral limit that
applies to both pre-tax elective and Roth
contributions
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Salary Reductions
• to determine “per employee limit” employee must
add together each year all elective deferrals from:
– Section 410(k) plans
– salary reduction SEPs est. before 1997
– SIMPLE IRAs
– Section 403(b) plans
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Salary Reductions
• employees over 50 can make “catch-up”
contributions
• plan may permit employees to make voluntary
contributions to “deemed IRA” established under the
plan
• contributions may count toward nonrefundable
‘savers credit’ for lower-income taxpayers
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Employer Contributions
Common types:
– formula matching
– discretionary matching
– pure discretionary or “profit sharing”
– formula contributions
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Plan Distributions
• subject to qualified plan distribution rules
• in-service withdrawals permitted
• elective deferrals cannot be distributed prior to
–
–
–
–
–
retirement, death, or disability of employee
severance from employment with employer
employee reaches age 59 ½
plan termination
hardship
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Plan Distributions
• early withdrawals that do not meet exceptions face
– income tax on amount withdrawn
– 10% penalty
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Plan Distributions
• withdrawals exempt from 10% penalty
– made after employee is age 59½
– due to employee’s death or disability
– part of a series of substantially equal periodic payments
following separation from service
– paid after separation from service after attaining age 55
– do not exceed amount of medical expenses deductible as
an itemized deduction for the year
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Design Features: Plan Distributions
• plan loans allows access to funds without the
hardship’ restriction or 10% penalty
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Tax Implications
• employee elective deferrals
-
income tax deferred
-
subject to Social Security tax for employer and employee
• sum of all types of employer contributions to 401(k)
deductible to 25% total payroll
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Tax Implications
• elective deferrals (not nonelective employer
contributions) subject to
-
social security (FICA)
-
federal unemployment (FUTA)
• elective deferrals must meet ADP test for
nondiscrimination <add in plan details>
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Tax Implications
• annual additions to each participant account faces
Sec. 415 limits -- the lesser of
-
100% of compensation
or
-
$49,000 (2009)
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Tax Implications
annual additions are sum of:
nonelective employer contributions to participant account
salary reductions or other elective deferrals contributed to
account
forfeitures from other participant’s account
after-tax employee contributions to the account
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Tax Implications
• distributions from plan taxed when employee
receives them
• limited nonrefundable tax credit (saver’s credit)
available to certain lower income taxpayers who
make salary deferrals
• certain employers may be eligible for business tax
credit of up to $500 for ‘qualified start up costs’
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
How to install a plan
• plan installation follows rules for qualified plans
• plan participants must complete elective deferral or
salary reduction forms before plan’s effective date
• safe harbor or SIMPLE 401(k) must provide note of
plan availability prior to commencement of plan year
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
How to install a plan
• effective employer-employee communication
essential
• if contributions of non-HCEs threaten loss of
nondiscriminatory status, employer can adopt safe
harbor or SIMPLE 401(k) to remove plan from ADP
testing.
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
True or False?
1. A Section 401(k) plan can be funded entirely from
employee salary reductions.
2. Unlike qualified pension plans, Section 401(k) plans
allow in-service withdrawals for certain specified
‘hardships’
3. A Section 401(k) plan is advantageous for relatively
older workers entering the plan
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
True or False?
4.
A worker is always 100% vested in all additions to
their Section 401(k) plan.
5.
Employees can elect salary reductions either before
salary earned or within a month after earnings have
been received.
6.
Section 401(k) plans that permit employees to make
contributions to a “deemed” IRA under the plan
reduce the limit for traditional or Roth IRA
contributions.
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Section 401(k)
Chapter 20
Employee Benefit & Retirement Planning
Discussion Question
How can an employer provide retirement benefits to
replace 401(k) benefits lost by an executive as a result
of the $245,000 (2009, indexed) compensation cap?
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