A 401(k) plan is a qualified employer-sponsored plan that provides eligible employees with the opportunity to make pre-tax salary deferral contributions to the plan. The employer may also opt to make non-elective or matching contributions to the plan on behalf of eligible employees. 401(k) plans remain immensely popular today, presumably because of the significant tax advantages they offer. First, employees electing to make pre-tax salary deferral contributions to the plan can reduce their taxable income (deferred wages are not subject to federal income tax). Additionally, since taxation is deferred until withdrawal, earnings on the deferral contributions accrue tax-free. Further, of particular importance to the employer, non-elective and matching contributions to the plan are tax deductible on the employer’s federal income tax return to the extent allowable under IRC§404.
To preserve its tax-favored status, a 401(k) must be able to demonstrate that it meets all of the requirements set forth by the IRS. A quality third-party administrator (TPA) is an important partner to help you navigate the complex rules. Two obstacles, in particular, can be troublesome to employers sponsoring a traditional 401(k) plan. First, “highly compensated” employees must not unfairly benefit from the plan. Second, a plan is considered top-heavy if the “key employee(s)” hold a disproportionate percentage of the plan’s assets. Please see the Compliance FAQs area for a brief overview of some of the relevant compliance tests and plan limits and a definition of highly compensated and key employees. This FAQ is not intended to be a comprehensive listing.
FAQs with Compliance Definitions
A 401(k) plan that contains a roth feature allows eligible employees to designate some or all of their deferrals as Roth deferrals. A Roth 401(k) plan offers another tax-advantaged option to plan participants. Unlike pre-tax salary deferrals, Roth deferrals are contributed on a post-tax basis. While the earnings accrue on tax-deferred basis, the biggest advantage is that withdrawals from the Roth account are fully tax-free provided certain conditions are met.
Safe Harbor 401(k) Plans are a popular choice today and are especially attractive to small employers. Safe harbor plans require that the employer contribute either an employer matching contribution or a non-elective contribution to all eligible non-highly compensated employees. Additionally, the employer contributions must be 100% vested. In exchange, the plan is generally exempt from non-discrimination and top heavy requirements provided certain conditions are met. Exempt from non-discrimination testing and top heavy requirements, the path is cleared for business owners and other highly paid employees to maximize their (deferral) contributions to the plan without the risk of incurring refunds. Based upon the popularity of this plan design, it’s clear that many plan sponsors have found the trade-off to be well worth the cost. To satisfy Safe Harbor Requirements, the plan must at minimum:
- Provide a mandatory employer contribution (see chart below).
- Fully vest the employer contribution.
- Provide an annual notice, at least 30 days (but not more than 90 days) prior to the start of a plan year, indicating that the company is electing to be a Safe Harbor Plan for the next plan year.
- Participant withdrawals of safe harbor contributions are subject to restrictions.
The following employer contributions are the minimum necessary to satisfy the ADP and ACP safe harbors:
- A Non-Elective contribution
- of at least 3% of pay
- A matching contribution that meets or exceeds one of the formulas noted below
- Basic Safe Harbor Match
- 100% of the first 3% deferred, plus
- 50% of deferrals between 3% and 5%
- Enhanced Safe Harbor Match
- 100% of the first 4% deferred
- Basic Safe Harbor Match
Usually listed as completely discretionary, the profit sharing component gives the Plan Sponsor more flexibility at year end. This flexibility makes it a great retirement plan option for businesses of any size. If the employer does decide to make a profit sharing contribution in a given year, the company must follow a pre-determined formula for deciding which employees are allowed to share in the profit sharing and how much. Of course, the IRS sets limits on the maximum amounts that can be contributed by the company and for each employee. They also require additional testing on the amounts that are given to ensure that the Non-Highly Compensated Employees (NHCE’s) are not being discriminated against.
Profit sharing contributions are a type of employer non-elective contribution. A profit sharing contribution can be a great option for employers of any size who are seeking more flexibility at year end. Profit sharing contributions are completely discretionary, meaning the employer has complete discretion over whether a contribution will be made for the plan year. Employers looking for the ultimate flexibility may find value in a cross-tested plan design since, unlike traditional allocation methods, a cross-tested design allows the employer to specify different allocation rates to different groups of employees. While this type of plan design doesn’t necessarily work for all employers, if the demographics of the company’s workforce are favorable, a cross-tested allocation can target the business owner(s) and/or other key personnel. Of course the IRS sets limits on the amounts that can be contributed and mandates additional testing to assure the allocation is non-discriminatory. A quality TPA is a valuable resource to help you design an allocation that both fits your goals and satisfies the additional compliance requirements.
A Solo(k) is a traditional 401(k) plan that covers only the business owner(s) and their spouse(s). While they are subject to the same qualification standards as any other 401(k), a solo(k) plan automatically satisfies non-discrimination testing since it covers only highly-compensated employees. It is important to note that if the business hires a (non-spouse) employee, it is imperative to closely monitor whether the employee will meet the plan’s eligibility requirements. If a non-highly compensated employee becomes eligible for plan participation, there can be unexpected testing complications.
A 403(b) plan is a tax-advantaged retirement plan for employees of non-profit entities. These plans are handled very similarly to the 401(k) plan. The main difference with 403(b) plans is that deferrals must be offered to most employees as of date of hire, where 401(k) plans can implement a waiting period to become eligible.
All businesses experience competition. In the construction industry when a company works on a state, local, or federal government project, the employees can be subject to the Davis-Bacon Act, which requires that the company pay non-union employees the “prevailing” wage and benefits. This compensation can be paid as an hourly wage or a fringe benefit or both. More and more employers are shifting the fringe benefit part into a qualified plan to eliminate taxes, reduce payroll related compensation premiums, and reduce insurance premiums.