401(k) plan

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Code Section 401(k) permits employees to defer portions of their future compensation into a qualified retirement plan. The typical "401(k) plan" is a participant-directed, defined contribution plan with such an elective deferral feature. However, a 401(k) feature may also be offered by a nonparticipant-directed plans, such as an ESOP.


Contents

Entities Permitted to Establish

For-profit entities are the usual sponsors of 401(k) plans. However, governmental entities, tax-exempt corporations, and tribal entities may also sponsor 401(k) plans under certain circumstances.

Participation

The salary deferral component of a 401(k) plan may require up to one year of service and the attainment of age 21 for eligibility. (Other components of a 401(k) plan -- like all qualified plans -- may require up to two years if the plan provides for immediate full vesting.)

Contributions

Employee Contributions

Pretax Elective Deferrals

The heart of a 401(k) plan is a "cash or deferred arrangement" (CODA), a arrangement under which the employee may forego salary in exchange for contributions to the 401(k) plan. Such contributions are not included in an employee's federal income tax, and thus are "pretax." (Notably, 401(k) contributions remain subject to FICA taxes.)

Roth Feature

401(k) plans may include a "Roth" feature, under which the employee may make after-tax contributions that may be eligible for tax-free distribution.

Deferral Limits for Pretax and Roth Contributions

Pretax and Roth elective deferrals are subject to the limits in Code Section 402(g). Beginning in 2006, the deferral limit was $15,000 (or, if less, 100% of salary). This limit is raised by $5000 (as of 2006) for any participant who will attain age 50 by the end of the tax year. See Catch-up Contributions.

Both limits are adjusted annually for inflation. See Dollar Limitations for current limits.

Other Employee After-tax Contributions

401(k) plans may also accept after-tax contributions from employees that are not Roth contributions. These limits are subject to the overall limits on contributions to a defined contribution plan, but not the 402(g) limits.

Timing

Elective deferrals become plan assets on (and thus must be remitted to the plan no later than) the earliest date on which such contributions can reasonably be segregated from the employer’s general assets.

Under regulations issued in 1996, the outer limit for participant contributions to a pension plan was set at the 15th business day of the month following the month in which participant contributions are received by the employer (in the case of amounts that a participant or beneficiary pays to an employer), or the 15th business day of the month following the month in which such amounts would otherwise have been payable to the participant in cash (in the case of amounts withheld by an employer from a participant’s wages).

A safe harbor exists for plans with fewer than 100 participants. Elective deferrals for these plans that are deposited within 7 business days fall within the safe harbor.

See plan assets for more information.

Employer Contributions

Matching Contributions

Many 401(k) plans match employee contributions, typically by contributing a percentage of the employee's deferral up to a certain percentage of compensation. For example, a plan might match 100% of an employee's deferrals up to 3% of compensation, and 50% of an employee's deferrals up to 6% of compensation. A matching contribution within certain ranges can be used to automatically meet nondiscrimination requirements.

Nonelective Contributions

401(k) plans may also make nonelective contributions, such as 3% of each employee's compensation. Nonelective contributions are often used to automatically meet nondiscrimination requirements.

Profit Sharing

401(k) plans may also include discretionary profit-sharing contributions by an employer. Note that under present law, there is no requirement that an employer actually have profits in order to make a profit sharing contribution.

Limit on Annual Additions

Under Code Section 415, total annual additions to a defined contribution plan cannot exceed the lesser of 100 percent of a participant's salary or $40,000 (indexed for inflation -- see Dollar Limitations for current limits).

401(k) Plan Discrimination Testing

401(k) plans must satisfy the general nondiscrimination standards applicable to qualified plans under Code Section 401(a)(4). They must also satisfy the ADP and (unless the plan does not offer matching or after-tax contributions) ACP testing requirements.

ADP Test

ADP is a measure of the elective salary contributions of highly compensated employees relative to nonhighly compensated employees. See ADP for a detailed discussion of the test and how to run it.

ACP Test

ACP testing is similar to ADP testing, but performed on matching and after-tax contributions. See ACP for a detailed discussion of the test and how to run it.

Safe Harbor 401(k) Plans

A plan will automatically satisfy the ADP and ACP tests (except the ACP testing for non-Roth, after-tax employee contributions) if the plan design falls into one of three safe harbors. The plan must provide that it will do one of the following:

1. Make a 100 percent match up to 3 percent of compensation, and 50 percent from 3 to 5 percent of comepnsation while providing a rate of match for NHCEs at least as great as that for HCEs. This match must be fully vested.

2. Make a nonelective contribution to NHCEs of 3 percent or more of compensation. This contribution must be fully vested.

3. Satisfy the safe harbor for an automatic enrollment QACA.

Notice

A safe harbor plan must provide a notice that it is a safe harbor plan to all participants prior to the beginning of a plan year. See 401(k) safe harbor notice for content details and timing requirements.

Disadvantages

A safe harbor contribution must be made to all eligible participants, even if they are not employed at the end of the year or have not met minimum hours requirements.

Definition of Compensation

A safe harbor 401(k) plan must use a definition of compensation for matching or employer contribution purposes that complies with Code Section 414(s).

Vesting

Employee Contributions

Employee contributions of any type of a 401(k) must vest 100 percent immediately.

Employer Contributions

Current Rules

For plan years beginning in 2007, all employer contributions to defined contribution plans -- including 401(k) plans -- must vest with at least 3-year cliff vesting (i.e., 100 percent vesting after three years of service), or 6-year graded vesting according to the schedule below:

Graded Vesting Schedule for DC Plans
Years of Service Vesting Percentage
2 20%
3 40%
4 60%
5 80%
6 100%

Before the PPA

Prior to the PPA, matching contributions had to vest at least as fast as 3-year cliff vesting or the 6-year graded vesting described above. Other employer contributions to defined contribution plans, however, could vest according to 5-year cliff vesting or 7-year graded vesting.

Events That Trigger 100% Vesting

A number of events may cause benefits that are otherwise subject to a vesting schedule to become fully vested, including reaching normal retirement age, plan termination, and complete discontinuance of contributions. See Vesting for more details.

Top-heavy Plans

Top-heavy plans are plans under which key employees have accrued more than 60 percent of all benefits. Top-heavy plans are subject to special vesting and minimum benefit requirements. See Code Section 416.

Distributions

401(k) plans typically distribute benefits in the form of a cash lump-sum payment.

In-Service Distributions

Employees may receive benefits prior to termination in some circumstances. Salary deferrals may be distributed at age 59 1/2 to participants. Employer contributions may be distributed at the plan's normal retirement age (or earlier, if permitted by the plan under the 24/60 rule). Rollover contributions may be distributed at any time.

Hardship Distributions

A hardship distribution is a special in-service distribution granted in cases of "immediate and heavy financial need." See hardship distributions for details.

Loans

401(k) plans often permit participants to take a loan equal to some or all of their vested balances. Such loans are secured by the participant's interest in the plan. The terms of the loan -- including period and interest rate -- must be commercially reasonable.

The maximum loan is the lesser of (1) $50,000 or (2) the greater of 50% of the participant's vested benefit or $10,000. See Code Section 72(p).

Missed loan payments cause an immediate deemed distribution. However, plans may permit cure periods that last until the last day of the calendar quarter after which the quarter in which the missed payment occurred.

Loans payments may be suspended during a leave of absence for up to one year. However, interest continues to accrue during this time.

Required Minimum Distributions

401(k) plans, like all qualified plans, must comply with the rules regarding Required Minimum Distributions for participants of age 70 1/2 or more.

Distributions at Separation from Service

Distributions from a 401(k) plan are generally taxable unless they are rolled over (see Rollover for more information) or are qualified Roth distributions.

Distributions made before age 55 are subject to an additional 10% penalty tax.

Blackout Periods

When switching recordkeepers or during a merger, it may be necessary to temporarily halt participant trading in a plan for a period of time. This is known as a "blackout period." See blackout period for information on the notices required and applicable regulations.

Termination

Alternative Defined Contribution Plan Rule

Distribution of amounts attributable to elective contributions under a 401(k) plan may not be made upon plan termination if the employer establishes or maintains an alternative defined contribution plan within 12 months before or after distribution. See Treas. Reg. 1.401(k)-1(d)(4).

An alternative defined contribution plan is any other defined contribution plan (but not defined benefit plans, ESOPs, 403(b) plans, 457(b)plans, SIMPLE IRAs, or SEPs) maintained by the same employer. There is an exception to the rule which provides that if at all times during the 24 month period beginning 12 months before the termination, fewer than two percent of the employees who were eligible under the 401(k) plan as of the date of plan termination are eligible under the other defined contribution plan, the other plan is not an alternative defined contribution plan.

The alternative defined contribution plan rule can make it advantageous in a merger or acquisition to terminate the dissolving entity's 401(k) plan prior to the transaction. Because the employer is determined as of the date of plan termination, the 401(k) plan's assets can be distributed, but former participants who are now employees of the new employer will still be able to participate in its 401(k) plan.

Correcting Errors

Qualification Errors

Errors that affect the qualification of a plan should be corrected using EPCRS.

The IRS 401(k) Fix-it Guide provides a helpful list of problems and corrective procedures.

Fiduciary Breaches

Certain fiduciary breaches (such as a failure to timely forward salary deferrals) may be corrected using the DOL's correction program, the VFCP.

How to Fix Common Errors

Failure to File Form 5500

Failing to file Form 5500 is a common error that can be corrected using a DOL corrective program called DFVCP.

Failure to Honor Employee's Salary Deferral Election

If an employer fails to honor an employee's salary deferral election, the employer must make a corrective contribution of 50% of the missed deferral (adjusted for earnings) on behalf of the affected employee. The employee is fully vested in these contributions, which are subject to the same withdrawal restrictions that apply to elective deferrals. The corrective contribution is based on the participant’s actual election.

Before correcting for the exclusion, however, the plan must evaluate whether, in the event that the employee had made the missed deferral, the plan would still pass the applicable ADP test. The ADP test should be corrected according to the plan’s terms before implementing any corrective contribution on behalf of the employee. In addition, the missed deferral amount should be reduced, if necessary, to ensure that the employee’s elective deferrals (the sum of deferrals actually made and the missed deferrals, for which a corrective contribution may be required) comply with all other applicable plan and legal limits.

Excess Contributions and Excess Aggregate Contributions

Excess contributions that cause ADP testing failures and excess aggregate contributions that cause ACP testing failures can be corrected by distributing excess employee contributions and earnings. Employer contributions causing ACP failures can be forfeited or corrected by greater contributions (through a QMAC or QNEC) to NHCEs.

Guidance

Final Regulations

  • 401(k) Final Regulations (includes 401(m) regulations) -- the final 401(k) regulations apply to plan years beginning on or after January 1, 2006.

Guidance on Fees

See also plan fees.

Other Guidance

  • IRS 401(k) Plan Checklist -- A helpful checklist of requirements needed to keep your 401(k) plan in good standing with the IRS.
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