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401(k)

What is a 401(k) Plan?

The “401(k) plan,” the popular name for a qualified cash or deferred arrangement (CODA) permitted under Section 401(k) of the Internal Revenue Code (IRC), has become one of the most popular types of employer-sponsored retirement plans.

  • Tip

A qualified cash or deferred arrangement can be included as part of a profit-sharing plan, stock bonus plan, pre-ERISA money purchase pension plan, or rural cooperative plan.

With a 401(k) plan, an employee can elect either to receive cash payments (wages) from his or her employer immediately, or to defer receipt of a portion of that income to the plan. The amount deferred (called an “elective deferral” or “elective contribution” or “pre-tax contribution”) isn’t currently includable in the employee’s income; it’s made with pre-tax dollars. Consequently, the employee’s federal taxable income (and federal income tax) that year is reduced. The deferred portion is taxed to the employee when it’s withdrawn or distributed.

  • Example

Assume Melissa is employed by a department store. She earns $30,000 annually. Melissa defers $5,000 of her earnings to the store’s 401(k) plan. As a result, Melissa’s taxable income is now $25,000. She isn’t taxed on the deferred money ($5,000) until she receives a distribution or makes a withdrawal.

  • Caution

State tax laws may differ from federal law. Consult your pension advisor for the tax impact in your particular state.

  • Caution

Special rules apply to SIMPLE 401(k) plans and safe harbor 401(k) plans (see Questions & Answers, below).

Roth 401(k)s

A 401(k) plan can allow employees to designate all or part of their elective deferrals as qualified Roth 401(k) contributions. Roth 401(k)contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pre-tax contributions to a 401(k) plan, there’s no up-front tax benefit, but if certain conditions are met, employees’ Roth contributions and earnings are entirely free from federal income tax when distributed from the plan.

Separate accounts must be established within a 401(k) plan (the “Roth accounts”) to track each employee’s Roth contributions and any gains or losses on those contributions. The taxation of distributions from the Roth account is also determined separately from any other 401(k) plan dollars.

  • Note

Employers don’t have to allow Roth contributions to their 401(k) plans.

Contributions in general

Employee contributions

Whether an employee elects to make pre-tax contributions or Roth after-tax contributions to the 401(k) plan, careful attention must be paid to the elective deferral limits. In 2020, an employee can’t contribute more than $19,500 (up from $19,000 in 2019) of his or her salary to a 401(k) plan. Participants who are age 50 or older may also make additional “catch-up” contributions of up to $6,500 in 2020 (up from $6,000 in 2019). Other limits also apply (discussed later).

Employer contributions

To encourage employee participation, some employers offer to “match” employee contributions under a specific formula. For example, you might decide to match 50 cents on every dollar contributed by employees up to a maximum of 10% of each employee’s salary. As an employer, you also have the option of making discretionary contributions (“non-elective contributions”) to the employees’ accounts. These contributions are subject to specific tests to ensure that they don’t discriminate in favor of highly compensated employees (see Questions & Answers for the definition of “highly compensated employee”).

  • Caution

Your employer contributions to the plan are always made on a pre-tax basis. That is, your employees aren’t taxed on these contributions until they’re distributed from the plan. This is true even if you choose to match employees’ Roth contributions.

  • Tip

In 2020 annual additions to an employee’s plan account (or accounts, if the employer offers more than one defined contribution plan) can’t be more than $57,000 (up from $56,000 in 2019) or, if less, 100% of that employee’s compensation. Employees age 50 or older can make catch-up contributions of up to $6,500 in 2020 (up from $6,000 in 2019) over and above the annual addition dollar limit. Annual additions include employer contributions, forfeitures, and employee contributions (pre-tax, after-tax, and Roth). Further, the maximum tax-deductible employer contribution is limited to 25% of total compensation of all employees covered under the plan. (Employee pre-tax deferrals are deductible separately.) Compensation for this purpose can’t exceed $285,000 for any one employee in 2020 (up from $280,000 in 2019).

Generally, any employer is eligible to set up a 401(k) plan

All organizations except governmental entities are eligible to set up 401(k) plans. However, these plans may be particularly attractive to those employers who:

  • Employ over 25 employees
  • Have a sufficient number of non-highly compensated employees who will defer a portion of their salaries
  • Are willing to make employer matching and discretionary contributions to encourage deferrals, and
  • Are willing to spend the time and money that a 401(k) plan requires for plan design, administration, and communication

What are some advantages offered by 401(k) plans?

Your employer contributions are income tax deductible

Your business may currently deduct (from business income) employer contributions it makes to the 401(k) plan.

Employer contributions are discretionary

A 401(k) plan offers a certain amount of flexibility. When you establish a 401(k) plan, you choose whether you want to contribute to your employees’ 401(k) accounts. If you decide to contribute, you can match all or a portion of your employees’ contributions. You also have the flexibility to decide whether to make discretionary profit-sharing contributions each year.

  • Caution

Contributions are generally required if you adopt a safe harbor 401(k) plan, or if your plan includes a qualified automatic contribution arrangement (“QACA”). See Questions & Answers, below.

Employees can contribute with pre-tax dollars

Your employees can elect to receive a portion of their compensation in cash, or instead defer those dollars into your 401(k) plan on a pre-tax (salary-reduction) basis. The contribution is taken directly from the employee’s salary and invested in the 403(b) plan before any taxes are withheld. This means that the amount each employee defers to the plan is not included in his or her gross income. The employee pays less current income tax because his or her taxable income is lower than it would otherwise be. Employee pre-tax contributions are generally taxable when distributed from the plan.

Employees can make after-tax Roth contributions

If your plan permits, your employees can elect to designate all or part of their elective deferrals as Roth 401(k) contributions. Your employees’ Roth contributions are made on an after-tax basis. Roth 401(k) contributions don’t provide any up-front tax benefit, but they’re always tax free when distributed from the plan. Earnings on Roth contributions are also tax-free if paid to the employee in a qualified distribution.

  • Tip

Employee contributions (both pre-tax and Roth) are called “elective deferrals.” The annual limit for elective deferrals is $19,500 in 2020 (up from $19,000 in 2019), plus any applicable catch-up contributions.

  • Caution

You cannot have a 401(k) that allows only Roth contributions.

Earnings accrue tax deferred

Investment earnings on your contributions and your employees’ contributions accumulate tax deferred while inside your 401(k) plan. Earnings aren’t taxed to your employee until he or she takes a distribution from the plan, and earnings on Roth contributions are tax free if paid to the employee in a qualified distribution.

Employees have the option of receiving the cash immediately from you rather than deferring it to the plan

A 401(k) plan provides flexibility to your employees. Employees aren’t required to make contributions to the plan. If they do contribute, however, they can change the amount of their contribution, or even cease contributing altogether.

Employees may find it easier to save for retirement

Because employees make 401(k) contributions through payroll deductions, they may find it easier to save. The money is “out of sight, out of mind.”

Plan loans can be made available to plan participants

You may structure your 401(k) to allow employees to borrow as much as one-half of the vested benefits in their 401(k) plan account, to a maximum of $50,000.

  • Caution

All loans are required to bear a reasonable rate of interest, and must not be offered in a discriminatory fashion.

In-service withdrawals can be made available to plan participants

An employee’s ability to access his or her own elective deferrals to a 401(k) plan is limited by federal law. You can, however, structure the plan to allow certain in-service withdrawals. For example, you can let your employees withdraw their pre-tax contributions, and any investment earnings on those contributions, after they turn age 59½.

  • Note

The Bipartisan Budget Act of 2018 enacted changes to the 401(k) hardship distribution rules. The discussion below is based on new rules proposed by the IRS in November of 2018. Provisions are effective – but not required – as of January 1, 2019. As of January 1, 2020, certain changes will be required.

You can also let your employees withdraw their elective deferrals prior to age 59½ if the employee, or the employee’s spouse, dependent, or plan beneficiary incurs a financial hardship. Hardship withdrawals are permitted only for immediate and heavy financial need and only in an amount necessary to meet that financial need. Examples of immediate and heavy financial need include the need to:

  • Pay medical bills for your employee, and his or her spouse, children, other dependents, or plan beneficiary
  • Pay costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments)
  • Pay post-secondary tuition for your employee and his or her spouse, children, other dependents, or plan beneficiary
  • Prevent an eviction from or foreclosure of the employee’s principal residence
  • Pay funeral expenses for an employee’s spouse, children, other dependents, or plan beneficiary
  • Repair damage to the employee’s principal residence after certain casualty losses
  • Pay income tax and/or penalties due on the hardship withdrawal itself

In general, an employee can’t take a hardship withdrawal to the extent the employee is eligible for a non-hardship withdrawal or a loan from your 401(k) plan or from any other retirement plan you sponsor. (As a result of the Bipartisan Budget Act of 2018, the rule requiring an employee to exhaust all loan options before taking a hardship withdrawal expired at the end of 2018 plan years; however, plans may still impose this requirement through December 31, 2019.)

  • Caution

IRS regulations contain complex rules that apply to hardship withdrawals from 401(k) plans, and the rules have changed as a result of recent legislation. A pension professional can help guide you through the various options available to you.

  • Caution

Keep in mind that hardship distributions are subject to ordinary income tax. They’re also generally subject to the federal 10% additional penalty on distributions prior to age 59½ (unless an exception applies), and possibly a state penalty tax. Also, in some cases in 2019, an employee’s participation in your 401(k) plan may be suspended for at least six months following a hardship withdrawal. (As a result of the Bipartisan Budget Act of 2018, the prohibition on participation will not be permitted after December 31, 2019.) The taxation of hardship withdrawals from an employee’s Roth 401(k) account depends on whether the distribution is a qualified or nonqualified withdrawal (discussed in more detail below).

  • Caution

In 2019, the amount of a hardship withdrawal may be limited to the total amount of your employee’s contributions (pre-tax or Roth) to the plan, reduced by the amount of any previous hardship withdrawals. Investment earnings may not be available for hardship withdrawal in 2019, except for certain pre-1989 grandfathered amounts.

If your plan permits after-tax (non-Roth) contributions you can generally let employees withdraw those dollars at any time. And if you make regular matching or discretionary employer contributions to the plan, you can generally let employees withdraw those contributions after an employee reaches a specified age, after the employee has been a plan participant for at least five years, after the contribution has been in the trust for a specified period of time (at least two years), after the employee becomes disabled, or after the employee incurs a hardship. Beginning in 2019, plans may permit hardship withdrawals to include “qualified matching contributions” (QMACs), “qualified nonelective contributions” (QNECs), and safe harbor contributions, as well as earnings on those amounts.

  • Tip

You can also structure your 401(k) plan to allow “qualified reservist distributions.” A qualified reservist distribution is a distribution (1) to a reservist or national guardsman ordered or called to active duty after September 11, 2001, for a period in excess of 179 days or for an indefinite period, and (2) that’s made during the period beginning on the date of such order or call to duty and ending at the close of the active duty period. An individual who receives a qualified reservist distribution may, at any time during the two-year period beginning on the day after active duty ends, make one or more contributions to an IRA in an aggregate amount not to exceed the amount of the qualified reservist distribution. The dollar limitations otherwise applicable to contributions to IRAs don’t apply to, and no deduction is allowed for, these contributions. Qualified reservist distributions are exempt from the 10% early distribution penalty tax.

  • Tip

Keep in mind that you are not required to allow in-service withdrawals from your plan. The terms of your plan document control.

If your plan has discretionary (nonelective) profit-sharing contributions, it may be "integrated" with Social Security

Basically, this means that you can, within specific limits, allow your plan to pay more to higher-paid employees. This is because benefits provided by a qualified retirement plan and those provided by Social Security are viewed by the IRS as one retirement program. Because Social Security provides a higher percentage of salary benefit to lower-paid employees, the IRS may allow a 401(k) plan that has discretionary profit-sharing contributions to favor higher-paid employees within specific limits (this is known as permitted disparity).

Participants who are age 50 or older can contribute more than the limit

Individuals age 50 and older may make an additional yearly “catch-up” contribution to their 401(k) plans (over and above the regular employee elective deferral limit, and over and above the annual addition dollar limit). The catch-up contribution amount is $6,500 in 2020 (up from $6,000 in 2019), and is indexed for inflation. The purpose of this provision is to help older individuals increase their savings as they approach retirement. Catch-up contributions can be either pre-tax elective deferrals or, if your plan permits, after-tax Roth contributions.

Distributions from 401(k) plans may qualify for special tax treatment

If your employee elects to take his or her 401(k) balance in the form of a lump-sum distribution, and meets all necessary requirements, he or she may qualify for special income tax treatment. However, certain rollovers from or to the 401(k) plan may jeopardize your employee’s ability to take advantage of this special tax treatment.

Employees may qualify for the tax saver's credit

Certain low- and middle-income taxpayers may claim a partial, nonrefundable income tax credit (“Saver’s Credit”) for amounts contributed to 401(k)s and certain other retirement savings vehicles. The maximum annual contribution eligible for the credit is $2,000. In addition, the amount of the credit (if any) depends on your employee’s adjusted gross income (AGI). Only joint returns with AGI of $65,000 or less, head of household returns of $48,750 or less, and single returns of $32,500 or less are eligible for the credit. Here are the credit rates based on 2020 AGI limits:

Joint Filers Heads of Household Single Filers Credit Rate
$0 - $39,000
$0 - $29,250
$0 - $19,500
50% of contribution
$39,001 - $42,500
$29,251 - $31,875
$19,501 - $21,250
20%
$42,501 - $65,000
$31,876 - $48,750
$21,251 - $32,500
10%
Over $65,000
Over $48,750
Over $32,500
0%

To claim the credit, your employee must be at least 18 years old and not a full-time student or a dependent on another taxpayer’s return.

Your business may qualify for the small employer pension plan start-up tax credit

If you establish a new 401(k) plan, your business may be eligible to receive an income tax credit for 50% of the qualified start-up costs to create or maintain the plan in three tax years. The credit may be claimed for qualified costs incurred in each of the three years starting with the tax year when the plan became effective. The amount of the credit is limited in each of the three years to $500 to $5,000, depending on the number of employees.

Rollovers are allowed

In general you can, but you aren’t required to, let employees roll over assets from other retirement plans to your 401(k) plan. For example, you can allow participants to roll over pre-tax (but not after-tax) IRA funds to your plan. Pre-tax IRA funds generally include deductible contributions to the IRA, tax-deferred earnings, and rollovers of taxable dollars from other employer-sponsored plans. You can also let your participants roll over eligible taxable and nontaxable (after-tax) funds from another employer’s qualified, 403(b), governmental 457(b), or SIMPLE IRA plan to your 401(k) plan. The plan must receive after-tax contributions in a direct rollover and must account for those contributions (and any earnings) separately.

While you’re not required to accept rollover contributions to your plan, you must let employees roll over eligible distributions from your plan to an IRA or another employer’s retirement plan, if the other plan agrees to accept the contributions. Surviving spouses must also be given the option to roll over inherited 401(k) funds to the spouse’s own IRA or employer plan account. Beneficiaries other than surviving spouses may be given the opportunity to directly roll over inherited 401(k) funds to an inherited IRA.

  • Caution

When considering a rollover, to either an IRA or to another employer’s retirement plan, your employees should consider carefully the investment options, fees and expenses, services, ability to make penalty-free withdrawals, degree of creditor protection, and distribution requirements associated with each option. They should also weigh the pros and cons of either leaving the money in the current plan (if allowed) or taking a cash distribution.

Special rules apply to Roth 401(k) contributions and earnings. Distributions from an employee’s Roth account can only be rolled over to a Roth IRA or to a Roth account maintained in another employer’s 401(k), 403(b), or 457(b) plan. And a Roth 401(k) account can only receive a rollover contribution from another 401(k), 403(b), or 457(b) Roth account (not from a Roth IRA).

A rollover can be direct or indirect. With a direct rollover, the funds are moved directly from the 401(k) plan to an IRA or other employer plan. With an indirect rollover, the participant first receives the distribution from the plan, and then rolls it over to an IRA or to another eligible employer plan within 60 days. In either case, as long as the rollover follows all applicable rules, it will be treated as a tax-free transfer of assets. If an eligible rollover distribution is not directly rolled over to an IRA or another eligible retirement plan, you are required to withhold 20% from the taxable portion of the distribution for federal income tax purposes. (The participant will receive a credit for tax withheld when he or she files a federal income tax return for the year.)

  • Caution

The 60-day indirect rollover rules can’t be used to roll over the nontaxable portion of a 401(k) plan distribution to another employer plan. The direct rollover rules must be used. In addition, the receiving plan must agree to separately account for the nontaxable dollars and earnings.

  • Caution

Your plan must provide a timely notice [a “402(f) notice”] explaining the rollover rules, the withholding rules, and other related tax issues when making an eligible rollover distribution.

  • Caution

Certain distributions cannot be rolled over. These include:

  • Required minimum distributions (RMDs)
  • Certain periodic payments
  • Hardship distributions
  • Corrective distributions of excess deferrals, excess contributions, or excess annual additions (plus any income on those contributions)

“In-plan” conversions
A 401(k) in-plan Roth conversion (also called an “in-plan Roth rollover”) allows employees to transfer the vested non-Roth portion of their 401(k) plan accounts (for example, employee pre-tax and after-tax contributions, company contributions, and any investment earnings) into a designated Roth account within the same plan. Employees have to pay federal income tax now on the amount they convert (reduced by any basis the employee has in the converted funds), but qualified distributions from their Roth accounts in the future will be entirely income tax free. Also, the 10% early distribution penalty generally doesn’t apply to amounts converted (but that tax may be reclaimed by the IRS if an employee receives a nonqualified distribution from his or her Roth account within five years of the conversion).

While in-plan conversions have been around since 2010, they haven’t been widely used, because they were available only if employees were otherwise entitled to a distribution from the plan — for example, upon terminating employment, turning 59½, becoming disabled, or in other limited circumstances.

The American Taxpayer Relief Act of 2012 has eliminated the requirement that employees be eligible for a distribution from the plan in order to make an in-plan conversion. Beginning in 2013, if the plan permits, employees can convert any vested part of a traditional 401(k) plan account into a designated Roth account regardless of whether they are otherwise eligible for a plan distribution. The new law also applies to 403(b) and 457(b) plans that allow Roth contributions.

Here are some additional points about in-plan Roth rollovers to consider:

  • If an amount rolled over into a designated Roth account was subject to distribution restrictions prior to the rollover, then that amount will continue to be subject to the same distribution restrictions after the rollover.
  • If an in-plan rollover is the employee’s first Roth contribution to the plan, then the five-year period for determining qualified distributions begins on January 1 of the year in which the employee makes the in-plan rollover.
  • Amounts that are otherwise non-distributable may be rolled over into a designated Roth account only via a direct rollover. Amounts that are otherwise distributable from the plan may be rolled over using either a direct rollover or an indirect (60-day) rollover (however, a 60-day rollover will be subject to 20% withholding).
  • Your plan is not required to allow in-plan Roth rollovers. You may also limit the types of dollars that may be rolled over, and the frequency of rollovers.
  • If your plan allows, an in-plan Roth direct rollover can include an employee’s outstanding plan loan, if there is no change in the loan’s repayment schedule. The taxable amount is generally the balance of the loan at the time of the rollover.
  • Caution

Whether a Roth conversion makes sense financially depends on a number of factors, including an employee’s current and anticipated future tax rates, the availability of funds with which to pay the current tax bill, and when he or she plans to begin receiving distributions from the plan. Also, employees should consider that the additional income from a conversion may impact tax credits, deductions, and phaseouts; marginal tax rates; alternative minimum tax liability; and eligibility for college financial aid. Employees should consult a qualified professional before making a conversion.

Creditor protection

Funds held in a 401(k) plan are fully shielded from your employee’s creditors under federal law in the event of the employee’s bankruptcy. If your plan is covered by the Employee Retirement Income Security Act of 1974 (ERISA), plan assets are also generally fully protected under federal law from the claims of both your employees and your creditors, even outside of bankruptcy (certain exceptions apply). State law may provide additional protection.

What are some disadvantages associated with 401(k) plans?

You will need professional assistance to establish and administer your 401(k) plan

Like other qualified plans, a 401(k) plan is subject to reporting and disclosure requirements under the Employee Retirement Income Security Act (ERISA). Therefore, you’ll require professional assistance to establish and administer your plan.

Like all defined contribution plans, a specific benefit level isn't guaranteed

Unlike a defined benefit plan, a 401(k) plan doesn’t guarantee a specific benefit at retirement. Participants’ accounts are subject to market forces, so if plan investments perform badly, participants could suffer a financial loss.

Access to elective deferrals limited before termination of employment

In general, a 401(k) plan can distribute elective contributions and earnings to an employee only upon the employee’s death, disability, severance from employment, attainment of age 59½, hardship, or termination of the plan. The Pension Protection Act of 2006 also allows the payment of “qualified reservist distributions” (see “In-service withdrawals can be made available to plan participants,” above).

Various contribution limits apply to 401(k) plans

Several rules and limitations involving contributions to 401(k) plans exist, including:

  • Annual elective deferral limit: In 2020, employee elective deferrals (combined pre-tax and Roth) are limited to $19,500 (up from $19,000 in 2019). Employees age 50 or older can make catch-up contributions of up to $6,500 in 2020 (up from $6,000 in 2019) over and above the annual dollar limit.
  • Tip

This dollar limit applies per person, and across all employer boundaries. Consequently, an employee who has several jobs with different employers and participates in several plans can’t contribute more than a total of $19,500 in 2020 (plus any allowable catch-up contributions) to all plans. Deferrals to 401(k) plans, 403(b) plans, SIMPLEs, and SAR-SEPs are included in this limit, but deferrals to Section 457(b) plans are not. In addition, only employee pre-tax salary deferrals and after-tax Roth contributions amounts count. Employer contributions and employee traditional (non-Roth) after-tax contributions, if allowed, aren’t subject to this dollar limit.

  • Tip

Your employee is responsible for making sure the overall limit isn’t exceeded if he or she participates in plans of more than one employer during a calendar year.

  • Caution

If your employee contributes too much in any particular year, the employee must withdraw the excess by April 15 of the following year to avoid adverse tax consequences. If your employee fails to do so, the excess will be treated as taxable income both in the year contributed to the plan and again in the year the excess contributions (and earnings) are distributed from the plan. This applies to both pre-tax and Roth excess contributions.

  • Section 415 annual addition limit: Annual additions (the aggregate of employee contributions plus any employer contributions you make on behalf of the employee plus any reallocated forfeitures (see Questions & Answers, below, for the definition of reallocated forfeitures) may not exceed the lesser of $57,000 in 2020 (up from $56,000 in 2019) or 100% of the participant’s compensation. Participants age 50 or older can make catch-up contributions of up to $6,500 in 2020 (up from $6,000 in 2019) over and above this annual addition dollar limit. You must treat all qualified defined contribution plans you maintain as a single plan for purposes of calculating the annual additions limit.
  • Annual deduction limit: The maximum annual deductible employer contribution that you can make on behalf of all plan participants (in addition to employee pre-tax salary deferrals) is 25% of the compensation paid to all participants.
  • Tip

This 25% deduction limit isn’t per participant, but is a single overall limit based on total employer contributions and total participant compensation (up to $285,000 per participant in 2020).

Your 401(k) plan may not discriminate in favor of highly compensated employees

Basically, this means that your highly compensated employees (see Questions & Answers, below, for the definition of “highly compensated employee”) may not defer a substantially higher percentage of their compensation than non-highly compensated employees. In order to ensure that this is the case, your 401(k) plan is generally required to undergo annual nondiscrimination testing.

These tests compare the average contribution rates of your highly compensated employees and your non-highly compensated employees.

  • Technical Note

The “ADP test” compares the average rate (stated as a percentage of each employee’s compensation) of employee pre-tax and Roth elective deferrals. The “ACP test” compares the average rate of employer matching contributions and employee traditional (non-Roth) after-tax contributions.

  • Tip

You generally don’t have to perform annual non-discrimination testing if you create a “safe harbor” 401(k) plan, or if your plan includes a qualified automatic contribution arrangement. See below.

Your 401(k) plan may be subject to "top-heavy" requirements

A 401(k) plan is considered to be “top-heavy” if (as of the determination date) the total of the accounts of all key employees (generally the owners and officers of the business) exceeds 60% of the total of the accounts of all employees. If the plan is top-heavy, you must make a minimum contribution of 3% of pay to the accounts of all non-key employees. The top-heavy requirements generally do not apply to safe-harbor 401(k) plans, or to plans that include a qualified automatic contribution arrangement.

How do you establish a 401(k) plan?

Have a plan developed for your business

You’ll want a retirement plan specialist to develop a plan that meets all the necessary legal requirements. In addition, you’ll want the plan to serve the needs of your business. Here are some of the issues to consider (this is by no means a comprehensive list):

  • Determine the plan features most appropriate for your business – Carefully review your business, looking at factors such as your cash flow and profits, how much you and your employees will benefit from the plan, the tax deduction needed by your business, and employee population (tenure, age, salary, turnover), to determine plan features such as investment vehicles, employer match (if any), employee eligibility requirements, vesting, auto-enrollment, and safe-harbor provisions.
  • Decide if you will allow only pre-tax employee contributions, or if you will also allow employees to make Roth after-tax contributions – Roth contributions may make administration of the 401(k) plan a bit more complex.
  • Consider plan designs that reduce (or eliminate) the need to test for discrimination and top heaviness, including safe harbor 401(k)s and qualified automatic enrollment arrangements.
  • Decide if employees will direct their own investments – If so, decide if your plan will comply with Section 404(c) of ERISA, in order to limit the liability of plan fiduciaries for losses employees may incur as a result of their own investment decisions.
  • Choose the plan trustee (this may or may not be you) – The assets of the plan must be held in a trust by a trustee. The trustee has overall responsibility for managing and controlling the plan assets, preparing the trust account statements, maintaining a checking account, retaining records of contributions and distributions, filing tax reports with the IRS, and withholding appropriate taxes.
  • Choose the plan administrator – Administering the plan involves many duties, including managing the plan (determining who is eligible to participate in the plan, the amount of benefits, and when they must be paid) and complying with reporting and disclosure requirements. The plan administrator may also be responsible for investing plan assets and/or providing investment educational services to plan participants. The employer is legally permitted to handle these responsibilities in-house, but plan sponsors will frequently hire a third-party firm or financial services company to assist in performing recordkeeping and other functions of plan administration. Be sure to comply with ERISA’s bonding requirements, if applicable.

Submit the plan to the IRS for approval

Once a plan is developed, the written document should be submitted to the IRS, unless it is a previously approved prototype plan. Since there are a number of formal requirements (for example, you must provide a formal notice to employees), a retirement plan specialist should assist you in this task. Submission of the plan to the IRS isn’t a legal requirement, but it is highly recommended (for more information, see Questions & Answers, below). The IRS will carefully review the plan and make sure that it meets all of the legal requirements. If the plan meets all the requirements, the IRS will issue a favorable “determination letter.” If the plan doesn’t meet all the requirements, the IRS will issue an adverse determination letter indicating the deficiencies in the plan.

Adopt the plan during the year in which it is to be effective

You must officially adopt your plan during the year in which it is to become effective, so plan ahead and allow enough time to set up your plan before your company’s year-end. A corporation “adopts” a plan by a formal action of the corporation’s board of directors. An unincorporated business should adopt a written resolution in a form similar to a corporate resolution.

Provide a copy of the summary plan description, and other required disclosures, to all eligible employees

ERISA requires you to provide a copy of the summary plan description (SPD) to all eligible employees within 120 days after your 401(k) plan is adopted. A SPD is a booklet that describes the plan’s provisions and the participants’ benefits, rights, and obligations in simple language. On an ongoing basis you must provide new participants with a copy of the SPD within 90 days after they become participants. You must also provide employees (and in some cases former employees and beneficiaries) with summaries of material modifications to the plan. In most cases you can provide these documents electronically (for example, through email or via your company’s intranet site). ERISA may require that you also provide additional information to participants. For example, if you allow employees to direct their own investments, specific detailed information about the plan and its investments must be provided on a periodic basis.

File the appropriate annual report with the IRS

Most qualified plans must file an annual report (Form 5500 series) with the IRS. Simplified reporting rules apply to certain single participant plans. A single participant plan is generally one that covers only an owner (and his or her spouse) or only partners (and their spouses). In general, single-participant plans aren’t required to file a return for a plan year (other than the final plan year) if the total value of the plan’s assets at the end of the plan year is $250,000 or less.

What are the tax considerations?

Income Tax — Employer

Your employer contributions to a 401(k) can be deducted from income
If your business contributes to the 401(k) plan, it can currently deduct such contributions up to 25% of the total compensation of all participants. For purposes of calculating your maximum tax-deductible contribution, the maximum compensation base that can be used for any one plan participant is $285,000 in 2020 (up from $280,000 in 2019). Employee pre-tax salary deferrals are deductible in full separately from this 25% limit on other employer contributions.

Elective deferrals are subject to Social Security and federal unemployment payroll taxes
Employee elective deferrals (including pre-tax and Roth contributions), but not employer contributions, are subject to payroll taxes under the Federal Insurance Contribution Act (FICA), Federal Unemployment Tax Act (FUTA), and Railroad Retirement Act.

Your business may qualify for the small employer pension plan start-up tax credit
If you establish a new 401(k) plan, your business may be eligible to receive an income tax credit for 50% of the qualified start-up costs to create or maintain the plan in three tax years. The credit may be claimed for qualified costs incurred in each of the three years starting with the tax year when the plan became effective. The amount of the credit is limited in each of the three years to $500 to $5,000, depending on the number of employees.

Income Tax — Employee Pre-tax and Employer Contribution

Plan contributions and earnings are income tax deferred
Your employee’s pre-tax deferrals aren’t currently includable in the employee’s income — they’re tax deferred, and included in income only when distributed from the plan. Likewise, your employee isn’t taxed on any employer contributions you make to his or her 401(k) account until a distribution is taken from the plan. Similarly, investment earnings on employee pre-tax contributions and employer contributions grow tax deferred, and aren’t subject to income tax until withdrawn.

  • Caution

Taxable income from a 401(k) plan is taxed at ordinary income tax rates even if the funds represent long-term capital gains or qualifying dividends from stock held within the plan.

  • Caution

A federal 10% premature distribution tax may be assessed on distributions made prior to age 59½ (unless an exception applies), and possibly a state penalty tax, too.

Income Tax — Employee Roth Contributions

In general you can (but you aren’t required to) let your employees designate all or part of their elective deferrals as Roth 401(k) contributions. Because an employee’s Roth contributions are made on an after-tax basis, there is no up-front tax benefit. They’re included in your employee’s gross income at the time the employee contributes to the 401(k) plan. And because they’re made on an after-tax basis, an employee’s Roth contributions are tax-free when distributed from the plan. Investment earnings on an employee’s Roth contributions grow tax-deferred while they remain in the 401(k) plan. Whether they’re subject to tax when distributed depends on whether the distribution is qualified or nonqualified.

Qualified Distributions
If an employee receives a qualified distribution from his or her Roth account, the entire amount distributed, both the Roth contributions and investment earnings, is totally free from federal income tax. A qualified distribution is a payment from an employee’s Roth account that meets both of the following requirements:

  • The payment is made after your employee turns age 59½, becomes disabled, or dies, and
  • The payment is made after the end of the five-year period that starts with the year the employee makes his or her first Roth contribution to your 401(k) plan
  • Example

Nicole makes her first Roth 401(k) contribution to your 401(k) plan in December 2016. 2016 is the first year of Nicole’s five-year waiting period. The five-year waiting period ends on December 31, 2020.

  • Tip

You can let your employees roll over Roth contributions from another employer’s 401(k) or 403(b) plan to your Roth 401(k) plan. If your plan accepts these rollovers, then the five-year period starts with the year your employee made his or her first contribution to the prior employer’s plan (if that’s earlier than the year the employee first contributed to your plan).

Nonqualified Distributions
If a payment doesn’t satisfy the conditions for a qualified distribution, the portion of the payment that represents the return of your employee’s Roth contributions will still be tax-free, but the portion of the payment that represents earnings on those contributions will be subject to income tax and a potential 10% premature distribution tax (unless an exception applies).

A distribution that’s made before the five-year waiting period has elapsed will always be a nonqualified distribution. A distribution that’s made prior to age 59½, disability, or death (for example, a distribution to your employee upon termination of employment before attaining age 59½) will also always be a nonqualified distribution.

  • Tip

IRS proposed regulations provide that each distribution from a Roth 401(k) account is deemed to consist of a pro-rata share of an employee’s Roth contributions and investment earnings on those contributions.

Gift and Estate Tax — Employee

The value of the 401(k) account is included in the decedent’s gross estate
The entire vested value of a 401(k) plan death benefit is included in a deceased participant’s gross estate for federal estate tax purposes.

Saver's Credit

Your employees may qualify for the tax credit for IRAs and retirement plans
Some low- and middle-income taxpayers may claim a federal income tax credit for contributing to a 401(k) plan (or to certain other employer-sponsored retirement plans).

Questions & Answers

Which employees must you include in your 401(k) plan?

Generally, plan participation must be offered to all employees who are at least 21 years of age and who worked at least 1,000 hours for the employer in a previous year. For eligibility purposes, one year of service generally means a 12-month period during which the employee has at least 1,000 hours of service. Plan participation must also be offered to all employees who are at least 21 years of age with 3 consecutive 12-month periods during each of which the employee has at least 500 hours of service (12-month periods beginning before January 1, 2021, do not count). Two years of service may be required for participation in a discretionary employer contribution (if your plan has one) as long as the employee will be 100% vested immediately. The two-year service requirement can’t be required for employee pre-tax or Roth contributions. Consequently, if your plan includes both employee contributions and discretionary employer contributions, you could have two eligibility requirements. If you want, you can impose less (but not more) restrictive requirements. Many 401(k) plans don’t impose any age or service restrictions at all.

When does plan participation begin?

An employee who meets the minimum age and service requirements of the plan must be allowed to participate no later than the earlier of:

  • The first day of the plan year beginning after the date the employee met the age and service requirements, or
  • The date six months after these conditions are met

If you want, you can impose less (but not more) restrictive requirements.

  • Tip

Your plan can also provide for automatic enrollment once your employee is eligible to participate in your plan. For example, you could provide that an employee will be automatically enrolled in the plan at a 3% pre-tax contribution rate (or any other percentage) unless the employee elects a different deferral percentage, or chooses not to participate in the plan. This is sometimes called a “negative enrollment” because the employee must affirmatively act to change or stop contributions. You must notify the employee of the automatic enrollment procedures and allow the employee a reasonable amount of time to make a different deferral election. Automatic enrollment can help your plan satisfy nondiscrimination requirements, while also encouraging your employees to save for retirement. If you adopt a specific type of automatic enrollment provision, called a “qualified auto-enrollment arrangement,” or QACA, your plan won’t have to perform discrimination (or, in most cases, top heavy) testing. (See “What is an automatic enrollment arrangement,” below.)

What is a safe harbor 401(k) plan?

A safe harbor 401(k) plan is one that by design satisfies the ACP test that applies to employer matching contributions. The safe harbor requires that you make a fully vested contribution equal to either:

  • A dollar-for-dollar match of all non-highly compensated employee deferrals up to 3% of compensation and 50-cents-on-the-dollar match of deferrals between 3% and 5% of compensation, or
  • 3% of compensation for all non-highly compensated employees, regardless of whether these employees contribute to the plan

Employers using the safe harbor 401(k) rules must give each eligible employee a written notice of the employee’s rights and obligations under the plan that satisfies specific content and timing requirements.

What is an automatic enrollment arrangement?

Your plan can provide that employees will automatically be enrolled in your 401(k) plan as soon as they become eligible. Your employee will then have to affirmatively elect not to participate in the plan. There are several different types of automatic enrollment arrangements.

A basic automatic enrollment arrangement must state that employees will be automatically enrolled in the plan unless they elect otherwise and must specify the percentage of an employee’s wages that will be automatically deducted from each paycheck for contribution to the plan. The document must also explain that employees have the right to elect not to have salary deferrals withheld or to elect a different percentage to be withheld.

An eligible automatic contribution arrangement (EACA) is similar to the basic automatic enrollment plan but has specific notice requirements. An EACA can allow automatically enrolled participants to withdraw their contributions within 30 to 90 days of the first contribution.

A qualified automatic contribution arrangement (QACA) is a type of automatic enrollment arrangement that automatically passes IRS ACP discrimination testing requirements. The plan must include certain required features, such as automatic employee contributions (including annual increases), fully vested employer contributions [generally, the same as the contribution required in a safe-harbor 401(k) plan], and specific notice requirements.

What is a highly compensated employee?

For 2020, a highly compensated employee is an individual who:

  • Was a 5% owner (i.e., an employee who owns more than a 5% interest) of the employer during 2019 or 2020, or
  • Had compensation in 2019 in excess of $125,000 and, at the election of the employer, was in the top 20% of employees in terms of compensation for that year. (This $125,000 limit rises to $130,000 in 2020.)

In general, to be qualified (i.e., tax exempt), a plan must meet employee coverage tests that demonstrate that the plan doesn’t discriminate in favor of highly compensated employees. Under the most basic minimum coverage test, a plan may cover any or all of the highly compensated employees if it also covers a number of non-highly compensated employees that is at least equal to 70% of the percentage of highly compensated employees covered. For example, if the plan covers 100% of the highly compensated employees, then the plan must also cover at least 70% of the non-highly compensated employees of the employer; or if the plan covers only 50% of the highly compensated employees, then the plan must also cover at least 35% of the non-highly compensated employees of the employer (70% of 50% equals 35%).

When do employees vest in their 401(k) accounts?

Vesting is the process by which participants in a 401(k) plan or other retirement plan earn the right to nonforfeitable benefits under the plan. A 401(k) plan participant is always 100% vested in his or her elective deferrals, and any investment earnings on those amounts. Participants need not be immediately vested in your employer contributions (matching or discretionary contributions). But if your plan is subject to ERISA, then you must comply with that law’s minimum vesting standards.

Those standards require that employer contributions either (1) vest 100% after three years of service (“cliff vesting”), or (2) vest 20% for each year of service beginning with the participant’s second year of service and ending with 100% after six years of service (“graded” or “graduate” vesting). Of course, your vesting schedule can always be less (but not more) restrictive than ERISA’s requirements.

  • Caution

Plans that require two years of service before employees are eligible to participate must vest 100% after two years of service.

  • Tip

A plan can have a faster vesting schedule than the law requires (for example, 100% immediate vesting of employer contributions), but not a slower one.

What happens if an employee leaves employment before he or she is fully vested in your contribution?

The participant forfeits the non-vested portion of his or her account. In most 401(k) plans, forfeitures are reallocated to the accounts of the remaining participants. Also called reallocated forfeitures, these forfeitures can be used to reduce future employer contributions and/or administrative costs, as well. Forfeitures can’t be allocated to an employee’s Roth account.

Can an employee who contributes to a 401(k) plan also make tax-deductible contributions to a traditional IRA?

Possibly. In most cases, when a traditional IRA owner is not covered by an employer-sponsored retirement plan, his or her contributions to the traditional IRA are fully tax deductible for federal income tax purposes. However, when the traditional IRA owner (or his or her spouse) is covered by such a plan [including a 401(k) plan], the ability to make tax-deductible IRA contributions may be limited or even phased out entirely. The amount of the tax deduction (if any) would depend on the IRA owner’s federal income tax filing status and modified adjusted gross income (MAGI) for the year. (Note that employees can generally make after-tax contributions to a traditional IRA regardless of how much they earn, and regardless of whether they or their spouse are covered by an employer sponsored retirement plan.)

Can an employee who contributes to a 401(k) plan also contribute to a Roth IRA?

Yes, participation in a 401(k) plan has no impact on an employee’s ability to contribute to a Roth IRA. However, annual contributions to a Roth IRA may be limited depending on your employee’s filing status and modified adjusted gross income (MAGI) for the year.

Do you have fiduciary responsibility for your employees' 401(k) accounts?

  • Caution

This section assumes that your 401(k) plan is subject to ERISA. Special considerations apply to plans that are not subject to that law.

Self-directed plans and ERISA Section 404(c)
You (or the applicable plan fiduciary) have a fiduciary responsibility to exercise care and prudence in the selection and appropriate diversification of plan investments. Failure to meet that duty could result in your liability to the plan for any losses incurred. You may even have liability for imprudent investment choices by your employees if your plan allows participants to select the investments in their account (“self-directed plans”). However, you may be able to limit your liability for investment losses that occur as a result of a participant’s exercise of investment control over his or her own account if you satisfy the requirements of Section 404(c) of ERISA. Section 404(c) requires that you:

  • Allow participants to choose from a broad range of investments with different risk and return characteristics
  • Allow participants to give investment instructions at least as often as every three months
  • Give participants the ability to diversify investments generally and within investment categories, and
  • Give each participant sufficient information to make informed investment decisions.

Default investments
If you adopt an automatic enrollment arrangement (for example, a QACA), you may have situations where a participant is contributing to the plan, but has not yet made an affirmative investment election. If your employee has not made an affirmative investment election you (or the applicable plan fiduciary) may have a fiduciary duty under ERISA to invest automatic enrollment contributions in a prudent manner for that participant, and you could be liable for investment losses if your plan’s default investments are deemed imprudent. However, you can avoid this potential liability if your plan’s default investments are “qualified default investment arrangements,” (QDIAs) as defined by U.S. Department of Labor (DOL) regulations.

DOL regulations provide for four types of QDIAs:

  • A product with a mix of investments that takes into account the individual’s age or retirement date (for example, a life-cycle or targeted-retirement-date fund)
  • An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (for example, a professionally managed account)
  • A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (for example, a balanced fund), and
  • A capital preservation product for only the first 120 days of participation (an option for plan sponsors who want to simplify administration for employees who opt out of participation).

A QDIA must either be managed by an investment manager, plan trustee, plan sponsor or a committee comprised primarily of employees of the plan sponsor, or be an investment company registered under the Investment Company Act of 1940. A QDIA generally may not invest participant contributions in employer securities.

Several additional requirements must also be satisfied:

  • Participants must have been given an opportunity to provide investment direction, but have not done so
  • A notice generally must be furnished to participants in advance of the first investment in the QDIA and annually thereafter
  • Participants must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least quarterly
  • DOL regulations limit the fees that can be imposed on a participant who opts out of participation in the plan or who decides to direct their investments
  • The plan must offer a broad range of investment alternatives, as defined in the DOL’s regulation under section 404(c) of ERISA
  • Caution

The DOL regulations do not absolve plan fiduciaries of the duty to prudently select and monitor QDIAs.

Investment education
If you sponsor a self-directed plan, you may assume an additional responsibility — participant education. A balance must be struck between providing not enough — or too much — investment educational support for plan participants. Too much and you could be considered to be providing investment advice, and become legally responsible for your employees’ investment decisions. Employee education is an issue to be carefully considered when implementing a qualified retirement plan.

Must you obtain a favorable determination letter from the IRS in order for your plan to be qualified?

No, a plan does not need to receive a favorable IRS determination letter in order to be qualified. If the plan provisions (both the written provisions and as implemented) meet Code requirements, the plan is qualified and entitled to the appropriate tax benefits. Nevertheless, without a determination letter, the issue of plan qualification for a given year doesn’t arise until the IRS audits your tax returns for that year. By that time, however, it is generally too late for you to amend your plan to correct any disqualifying provisions. Consequently, a determination letter helps to avoid this problem, because auditing agents generally won’t raise the issue of plan qualification if you have a current favorable determination letter. Alternatively, pre-approved “prototype” plans are often used.

What happens if the IRS determines that your 401(k) plan no longer meets the qualified plan requirements?

The IRS has established programs for plan sponsors to correct defects. These programs are designed to allow correction with sanctions that are less severe than outright disqualification. If, however, you are unable to correct the defects in your program appropriately, your plan may be disqualified. Loss of a plan’s qualified status generally results in the following consequences:

  • Employees are taxed on their pre-tax contributions in the year they’re made to the plan, rather than the year the contributions are paid from the plan
  • Employees are taxed on employer contributions, and all plan investment earnings, in the year they vest rather than the year benefits are paid
  • Your deduction for employer contributions must be taken in the year your employees vest in the contribution, rather than the year you made the contributions to the plan
  • The plan trust would have to pay taxes on its earnings
  • Distributions from the plan may be ineligible for special tax treatment and can’t be rolled over tax free
  • Caution

Note that a plan may be disqualified retroactively. This means that you and your employees would need to file amended returns to reflect the tax effects of disqualification for those prior years. Penalties for under-reporting income in those prior years could also be imposed. However, the IRS can generally not go back more than three years (six years if there was a substantial under-reporting of income). While the IRS wouldn’t be able to collect taxes for any earlier year, the Service might require correction of those closed years if you seek to re-qualify your plan.

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