the concepts that shape 401k plans
401k Plans Are Defined Contribution Plans
A 401k plan is what's called a defined contribution retirement savings plan. In 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 plans must be "sponsored" by an employer. Their very IRS-mandated operation -- i.e., that contributions are pulled from employees' pay BEFORE are taxes -- is predicated upon the plans being run through the employer.
401k plan sponsorship does not, however, mean the employer must contribute financially to its 401k plan. Please see topic 7, below, 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 Online, there is no such outside vendor).
The Plan Vendor
401k plans are supplied by a vendor, who typically supplies the 401k plan itself and all its related documentation. The vendor deals with the IRS and related governing agencies in making sure the startup plan is consistent with current regulations.
Often the vendor supplies 401k administration services, too. Sometimes the vendor even supplies its own lineup of 401k plan investments.
Third-party Administrators (TPAs)
Administration for a 401k plan can be legally supplied almost any party -- the plan vendor, the plan sponsor, or a third party -- so long as the plan is run in accordance with current regulations, among them IRS compliance testing stipulations.
The 401k "auto enrollment" procedure allows employers to AUTOMATICALLY enroll employees in the 401k plan as soon as the employee meets the plan's eligibility requirements. Employees can elect to decline enrollment at any time.
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 has only recently approved negative elections and certain legalities outside of the scope of the IRS remain unclear. It is prudent to consult a legal advisor before adopting automatic enrollment for your 401k plan.
Contributions to a 401k account can come from employees and/or their employers. Employee contributions are withheld from the participant's pay BEFORE income tax withholding is calculated. Thus, 401k contributions are pre-tax contributions.
Employees cannot contribute more than 15% of their annual earnings to their 401k account. Additionally, they cannot contribute more than $11,000 (for year 2002) of their annual earnings to their 401k account, a limit adjusted each year by lawmakers.
Contributions to a 401k account can come from employees and/or their employers. Employers choose whether or not to contribute to their employees 401k accounts. If they choose to contribute, they can do so in any of three ways:
Any employer qualified nonelective 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
There are federally mandated limitations as to how much an employee can contribute to his or her 401(k) plan annually, and how much the employer can likewise contribute to the company's plan. The following information and examples are provided by the IRS:
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 $20,500 for 2008 (the $15,500 regular limit for 2008 plus the $5,000 catch-up limit for 2008). If the plan didn’t permit catch-up contributions, the most Joe could defer would be $15,500. However, if Joe participates in two 401(k) plans, each maintained by an unrelated employer, he can defer a total of $20,500 even if neither plan has catch-up provisions. Of course, Joe couldn’t defer more than $15,500 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 2007 by April 15, 2008, it is includable in your gross income for 2007, but not for 2008. 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, 2008, the excess, though taxable in 2007, 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 $46,000 (for 2008, $49,000 for 2009). In addition, the amount of your compensation that can be taken into account when determining employer and employee contributions is limited. In 2008, the compensation limitation is $230,000; for 2009, the limit is $245,000.
Certain types of investments are "qualified" under the Internal Revenue Code to receive 401k contributions. These include:
Every 401k plan must offer a minimum spectrum of investments, as defined in the Internal Revenue Code.
With 401k Easy Online you have an unlimited selection of 401k investments. Please visit our Investments page for examples and details.
401k Investing and Tax-deferred Saving
All 401k contributions -- employee, employer and even returns earned on 401k investments -- are exempt from income taxation (in most cases state, in all cases federal) so long as the money remains in the plan. Delaying income taxation can have a dramatic positive effect on the compounding growth of an account:
Withdrawals and 401k Loans
Although 401k plans are meant to be long term savings vehicles, participants cannot leave money in a 401k account indefinitely:
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.
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
Two bodies of legal work comprise the framework for 401k plans: the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA).
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 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
To prevent employers from designing 401k plans that economically benefit only highly-paid personnel, lawmakers wrote compliance test mandates into the rules governing 401k plans.
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
401k compliance tests are designed to ensure 401k plans have a threshold balance, at minimum, of participation of rank-and-file employees in relation to highly-paid employees.
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 Online 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)
The Economic Growth and Tax Reconciliation Act of 2001 made several pertinent changes to federal 401k regulations. To view a secondary window listing the changes click here; unless otherwise stated, the EGTRA amendments took effect January 1, 2002.
401(k) Easy-For-One is an affordable and complete retirement plan that allows sole owners of one-person companies and one-person corporations to shelter a significant portion of their income -- in some cases, more than twice as much -- than they can shelter with other qualified retirement plans, such as money purchase pension plans, simplified employee pension (SEP) plans and savings incentive match plans for employees (SIMPLEs). It is estimated that nearly 18 million one-person business owners are eligible to participate in one-person 401(k) plans; Eligible businesses include corporations, sole proprietorships, and non-profits. Participants include accountants, lawyers, consultants, doctors, software programmers, etc.
401(k) Easy-For-One is made to fit owner-only businesses (including spouse) and businesses with employees that can be excluded under federal laws governing plan coverage requirements.
II. One-Person 401(k)s and Their Advantages Over SEP IRAs and SIMPLE IRAs.
One-Person 401(k) 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 401(k) 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 in a One-Person 401(k) cannot exceed 100% of pay, up to a maximum of $41,000 for those under 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 401(k) (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 401(k).
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 fifties with $100,000 in income could put away $41,000 for retirement this year with a One-Person 401(k); 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 401(k) plans. The plans can accept rollovers from virtually any type of retirement plan, including a corporate 401(k) 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 401(k) 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 401(k) to consolidate existing retirement accounts, and 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 401(k) without facing the penalties and taxes associated with a premature retirement plan distribution. The only requirement to establish an ad count is that you have self-employment income, so someone who is between jobs and doing consulting work would qualify. Loans must be repaid according to IRS guidelines as they would with a corporate 401(k), or become subject to taxes and penalties.
III. If you are considering a One-Person 401(k) be sure it includes the following 3 features, which are not typically available in plans provided by insurance companies and mutual fund companies, or plans priced less than $300 annually.
Benefits of 401k Easy Online-For-One
* Employer/owners may contribute up to $41,000 per year, depending on their income.
* 401(k) Easy-For-One contributions are made with "pre-tax" dollars, and earnings grow tax-deferred until withdrawn
*Employer/owners can make salary deferrals equal to 100% of compensation, up to a maximum of $12,000 for 2003. This maximum will increase by $1,000 per year until 2006, when it reaches $15,000.
* Employer/owners may also make company profit-sharing contributions up to 25% of salary.
* Employer/owners who are age 50 and above may contribute an additional "catch-up" contribution of $1,000 annually, in addition to the $40,000 maximum. This catch-up contribution maximum will increase by $1,000 per year until 2006, when it reached $5,000.
*If new employees are hired the 401(k) Easy system will immediately accommodate them---additional set-up and annual maintenance fees will apply.
*Rollovers into the 401(k) Easy-For-One are permitted from SEP, SARSEP, SIMPLE IRA, traditional IRA, rollover IRA, Keogh, 401(k), 403(b) and 457 plans.
*Loans are available to the employer/business owner via the 401k Easy Online-For-One.
*Employer/owners have complete control over their 401k Easy Online-For-One investments, as do all 401k Easy Online users.
* 401(k) Retirement Plans are Excluded from the Bankruptcy Estate
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 excludes from the bankruptcy estate retirement funds that are exempt from taxation under the Internal Revenue Code (the "Code")--such as one-person 401(k) plans, profit sharing plans, traditional 401(k) plans, defined benefit plans and IRAs. In addition, the Act protects tax-exempt retirement funds that are transferred to another tax-exempt retirement fund (i.e. a rollover to an IRA).
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.
Finally, 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. And, the Act 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. (Note that many states gave 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, which should be particularly beneficial to corporate officers, directors and other higher-compensated individuals. The Act becomes effective October 17, 2005. The Act will not apply to any bankruptcy cases filed prior to its effective date. And, it is important to note that its protections apply only if a participant has filed for bankruptcy.