401k contributions, ERISA, 401k compiance testing and 401k loans401k basics

 

401k Basics

1) 401k plans are "defined contribution plans."

A 401k plan is what's called a defined contribution retirement savings plan. In defined contribution plans...

-- the amount contributed to each participant's account is set ("defined") -- either by the plan participant or by the employer, and as either a flat rate or a percentage of pay.

AND...

-- the amount each participant will receive upon retirement is left up to the effect of investment performance on the contributions.

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...

-- Each participating employee decides the amount to be withheld each month from his or her pay as their 401k contribution.

-- The employer withholds these amounts BEFORE calculating income taxes on each employee's pay.

-- The employer forwards the money to a third party administrator, who  is responsible for investing the employees' contributions per specific instructions provided by the employees.

-- Some employers choose to add to participants' 401k contributions through employer matching contributions.

 

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2) The new 401k auto enrollment feature can improve participation rates.

The new "auto enrollment" procedure allows employers to AUTOMATICALLY enroll an employee in the 401k plan as soon as the employee meets the plan's eligibility requirements. Employees can elect to decline enrollment at any time.

-- The company must set the auto enrollment contribution level in advance; 3% to 5% of compensation is the typical auto enrollment contribution level chosen.

-- The company must set an auto enrollment investment selection ahead of time; a money market fund is the most typical auto enrollment investment.

-- Employers must, at least annually, notify all employees that the company 401k uses the auto enrollment feature and how an employee can cease participation in the plan.

-- Employers must immediately notify auto-enrolled employees of their new 401k participation status.

-- Any employer matching contributions being made to traditionally-enrolled participants' accounts must also be made to auto-enrolled participants' accounts.

-- Auto-enrolled plan participants must have the opportunity to change their default investment selection and/or contribution rate.

-- If an automatically-enrolled employee soon after cancels his or her participation in the plan, any money put into the plan on the person's behalf must stay in the plan until the person's employment is terminated, or the employee reaches age 65.  At that point, the employee has the same withdrawal choices (IRA rollover, rollover into another employer's qualified retirement plan, or distribution) as any 401k participant of the same age and employment status.

Automatic enrollment is also referred to as passive enrollment or negative enrollment; the automatic 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 IRS's scope remain unclear. Consulting a legal advisor would be prudent before adopting automatic enrollment for your 401k plan.

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3) Plan vendors supply and maintain your 401k; the employer sponsors it.

-- 401k plans are supplied by a vendor, or third-party administrator who typically supplies the plan itself and all its related documentation.

-- Investments for a 401k plan are sometimes supplied by the vendor and sometimes by another party, the investment custodian.

-- Administration of the 401k is sometimes supplied by the vendor and sometimes by another party, under contract to the vendor.

401k plans must be "sponsored" by an employer; they can only be offered through a sponsoring company. The Internal Revenue Code does provide for retirement savings plans that don't require employer sponsorship (these include annuities and Individual Retirement Accounts), but most people find 401k plans far superior:

-- 401k plans are extremely convenient for participants.

-- 401k plans allow for significantly higher annual contribution levels.

-- Higher contribution levels mean a greater impact on lowering participants' current income taxes.

-- Higher contribution levels mean more money being set aside -- and allowed to compound -- for retirement.

-- 401k plans can include loan features that allow participants to borrow from their retirement savings; IRAs and most annuities do not offer the  possibility of loans.

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 party providing the overall plan administration!).

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4) Employee 401k contributions are pre-tax contributions.

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 can also transfer their money into their current 401k from their previous employer's 401k in the form of a rollover. Consolidating accounts can simplify oversight and management of a comprehensive investment strategy under the direction and control of the plan participant.

-- Participating in a 401k plan can reduce a person's lifetime income tax burden, because income taxes aren't assessed on 401k contributions until the money is withdrawn from the plan, usually years down the road, during retirement, when the participant is likely in a lower income tax bracket.

Employees cannot contribute more than 15% of their annual earnings to their 401k account. Additionally, they cannot contribute more than $10,500 (for year 2000) of their annual earnings to their
401k account, a limit adjusted each year by lawmakers.

-- These limits apply to employee contributions only.

-- Employer contributions to an employee's account can take the total annual contribution amount much higher.

-- Returns earned on 401k investments are never included in these annual contribution limits and can be a substantial source of growth for a 401k account.

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5) Employer 401k contributions add to employees' accounts.

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 take are of three forms:

-- In a flat fixed-dollar amount to each participant's account (e.g., $500 to each participant's account annually)

-- At a fixed rate of each participant's pay (e.g., each participant gets an amount equal to 3% of his or her salary).  This is called a profit sharing contribution.

-- At a rate that depends on how much the employee contributes to the 401k plan, This is called a matching contribution.

Employer contributions do not have to immediately become the property of the employees. Instead, employers can require a vesting schedule by which the 401k participants gain full ownership of employer contributions incrementally, over time. For example...

-- An employer chooses to make matching contributions and chooses to do so at a rate of 25¢ to each dollar a participant contributes. This is the matching formula.

-- The employer stipulates that people who have participated in the plan two years or less only get 25% ownership of these employer-provided matching contributions. People who have participated in the plan three years get 50% ownership of the matching contributions. People who have participated in the plan four years get 75% ownership of the matching contributions, and people who have participated in the plan five years or more get 100% ownership of matching contributions. This schedule of ownership is an example of a vesting formula. It is relevant if a participant leaves the plan before reaching fully-vested status. Any non-vested employer contributions revert back to the plan and are later distributed among the remaining participants.

-- The  Internal Revenue Code places dollar amount ceilings and other restrictions on matching and vesting formulas.

-- Because matching contributions depend on the employee's level of participation (25¢ for every dollar the employee contributes, for example), they encourage employees to join the 401k, contribute as much money as they can, and stay with the company over the years!

-- Employers are NOT required to contribute to their employees' 401k accounts in any way. Employer contributions are completely voluntary on the part of the employer.

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6) Qualified investments for 401k plans

Certain types of investments are "qualified" under the Internal Revenue Code to receive 401k contributions. These include:
-- Mutual fund investments (stock, bond and money market funds). Mutual fund investments are by far the most popular 401k investments.

-- publicly traded stocks and bonds (excepting municipal or tax free bonds)

-- bank collective funds, and

-- insurance company investments.

Every 401k plan must offer a minimum spectrum of investments, as defined in the Internal Revenue Code.

-- Most plans offer between five and 15 investment choices.

-- Returns earned on 401k investments are automatically reinvested in the participants' accounts, increasing the account value over time.

-- Removing investment returns from a 401k, just like removing any other money from a 401k account, constitutes a withdrawal and is subject to the penalties and withholdings of such.

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7) 401(k) 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:

• The limit is $15,500 for 2008 and $16,500 for 2009.
• The limit is subject to cost-of-living increases after 2009.

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).

• The limit is $10,500 for 2008 and $11,500 for 2009.
• The limit is subject to cost-of-living increases after 2009.

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:

• The elective deferral limit increases by $5,000 for 2008 and $5,500 for 2009.
• The limit is subject to cost-of-living increases after 2009.

If you participate in a SIMPLE 401(k) plan and you are age 50 or older:

• The elective deferral limit increases by $2,500 for 2008 and 2009.
• The limit is subject to cost-of-living increases after 2009.

The catch-up contribution you can make for a year cannot exceed the lesser of the following amounts:

• The catch-up contribution limit, above, or
• The excess of your compensation over the elective deferrals that are not catch-up contributions.

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.

 

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Tax-deferred 401k saving means compounding growth potential.

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:
-- An investor can amass nearly THREE TIMES as much money in a 401k tax-deferred investment over a 30 year period as in a  taxable savings plan or investments earning the same rate of return but whose returns are reduced each year by income taxation!

-- When money is taken out of a 401k plan -- for ANY reason except a 401k loan or rollover into an IRA or new employer's 401k plan -- it is considered income and taxed as such.

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401k Withdrawals & 401k Loans

Although 401k plans are meant to be long term savings vehicles, participants cannot leave money in a 401k account indefinitely:

-- Plan participants generally MUST begin taking withdrawals from their 401k accounts when they reach age 70 1/2.

-- Plan participants CAN begin taking withdrawals from their 401k accounts as soon as they reach age 59 1/2.

-- Earlier withdrawals can be made without penalty if the participant dies or incurs a qualifying permanent disability.

-- At any time, a plan participant leaving the company can remove his or her 401k money without subjecting it to early withdrawal penalties by rolling the money over into a Rollover IRA or new employer's qualified retirement savings plan -- 401k or other.

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.

 

HARDSHIP WITHDRAWAL

  

401k LOAN

does NOT have to be paid back

must be paid back within the agreed-upon time (within six months if the participant leaves the company)

no interest

bear interest (market rate, or thereabouts)

substantial federal early withdrawal penalties

no federal early withdrawal penalties, unless the loan goes into default

one year suspension of 401k participation upon taking out of a hardship withdrawal

no participation suspension

substantial long-term negative effect on the compounding growth of the 401k account

less substantial long-term effect on the compounding growth of the 401k account -- but still a significant negative effect

sometimes asset liquidation fees

sometimes assets liquidation fees

plan participant generally ends up with about 1/2 of the amount withdrawn (the reminder goes to taxes and federal early withdrawal penalties)

plan participant generally ends up with most of the amount withdrawn

withdrawn money taxed as income for the year

no tax consequences (unless participant defaults on loan)

must be included in all 401k plans

does NOT have to be included in 401k plans

generally involve nominal administrative processing costs

generally involve nominal administrative processing costs

all other resources must have been exhausted for person to qualify

qualifications much less stringent

Hardship withdrawal and 401k loans increase a plan's popularity, because employees don't feel participation means sending their money into some never-to-be-seen-again abyss. Retirement, after all, may be decades away.

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ERISA helps protect 401k plan participants' rights and retirement savings.

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:

-- participant eligibility,

-- investment choice,

-- plan funding/bonding,

-- vesting,

-- disclosure of plan and investment information to current and prospective plan participants and their beneficiaries,

-- and more.

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 is different than an ERISA bond. Fiduciary liability insurance is a completely discretionary purchase on the part of the employer, and provides broad coverage for all persons who are de facto "fiduciaries" of the company's plan. A fiduciary is someone who provides investment advice to the plan for a fee, and/or has discretionary control or authority over the administration of the plan, an/or has authority or control over plan assets. (note: NASD Registered Representatives are not considered fiduciaries; they earn commissions on plan assets, and typically do not charge fees for investment advice.)

Fiduciary liability insurance is very inexpensive; the cost is approximately 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 to name a few.

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IRS 401k 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.

In general, no plan can be set up in a way that discriminates "as to the availability of rights, benefits and features" available to different employees under the plan.

Specifically...

Every 401k must pass mandated compliance testing every year. The tests compare the participation rates of different classes of employees (see below).

Beginning in 1999, employers can choose to skip the tests and instead make a requisite contribution to their so-called non-highly-compensated employees' 401k accounts. This is called the safe harbor method of plan administration.

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 (explain), 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..

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 re-file their income tax forms -- and often pay additional income taxes, too.

The most common compliance tests are the ADP test, ACP test, multiple-use test and top-heavy test.

The ADP test (Actual Deferral Percentage test) compares the percentage of salaries that different classifications of employees are diverting into the 401k plan.

The ACP test (Actual Contribution Percentage test) compares the percentage of employer contributions being diverted into the 401k accounts of different classifications of employees.

The multiple-use test compares the results of the ADP and ACP tests.

The top-heavy test looks at how much higher-paid employees' money dominates the 401k plan.

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Safe Harbor option

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.

To qualify a 401k plan as a safe harbor plan, an employer must make matching contributions that fulfill the below requirements or make nonelective contributions equal to 3% of each eligible employee's compensation.

Nonelective contributions are made to all eligible employees, regardless of if the employees participate in the company 401k plan. Matching contributions, on the other hand, being based upon salary deferral amounts, are made only to active 401k participants' accounts.

If the employer chooses to make safe harbor matching contributions, those contributions must meet two requirements: First, each non-highly-compensated employee must receive a dollar-for-dollar match on salary deferrals up to 3% of compensation and a 50¢ to the dollar match on salary deferrals from 3% to 5% of compensation. Second, the rate of any matching contributions being made to highly compensated employees cannot exceed that being made to non-highly compensated employees.

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 401(k) Easy 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.

If you don't choose the safe harbor method of 401k plan administration, we encourage you to use your customized 401k plan administration software's point-and-click compliance testing every month to keep well apprised of your plan's health.

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Economic Growth and Tax Reconciliation Act of 2001 (EGTRA)

 Issue

 Current Law

 EGTRA
Tax Credits for New Small Employer Plans An employer's costs related to the establishment and maintenance of a retirement plan generally are deductible as business expenses. However, there is no tax credit for such expenses. Beginning in 2002, small businesses with 100 employees or less will be eligible for an annual tax credit of 50 percent on up to $1000 of administrative costs for the first three years of a new plan. The credit is available only if at least one non-highly compensated employee is participating..
Participant Loans for Small Business Owners Generally, plans may make loans to participants. But, prohibited transaction rules prevent sole proprietors, partners, and Subchapter S corporation shareholders from taking participant loans. The prohibited transaction rules are modified to allow for participant loans to sole proprietors, partners, and Subchapter S corporation shareholders. The provision also applies prospectively to pre-existing loans.
Repeal of the Multiple Use Test In addition to two nondiscrimination tests (the ADP and ACP tests), some 401(k) plans must also satisfy the complicated multiple use test. The multiple test is repealed.
Tax Credits for Lower Income Savers Currently there is no tax credit for low and moderate income savers.

Eligible persons will receive a non-refundable tax credit of up to 50 percent on up to $2000 in contributions to an IRA, 401(k), 403(b), SIMPLE, SEP or 457 plan. This credit is in addition to the tax deduction already associated with these contributions.

In the case of joint filers, individuals whose adjustable gross income is less than $30,000 are eligible for a 50 percent credit. Joint filers with adjusted gross income between $30,000 and 32,500 are eligible for a 20 percent credit. Joint filers with income between $32,500 and $50,000 are eligible for a 10 percent credit. The income threshold for single filers is one-half the threshold for joint filers.

 

Catch-up contributions for Older Workers The Code limits the amount that can be contributed to a defined contribution plan on behalf of an employee for any year. In the case of elective deferrals, the limit is $10,500 per year. There are no separate limits for older workers.

Beginning in 2002, individuals who are age 50 or older will be allowed to make an additional contribution to a 401(k), 403(b), 457 plan equal to $1,000 in 2002, then increased by $1,000 each year until $5,000 in 2006, and then indexed in $500 increments. The catch-up amount for SIMPLE plans will be one-half of these amounts.

The amount of the catch-up contribution will not be subject to nondiscrimination testing, provided all participating employees over age 50 are eligible to make a catch-up contribution. Also the catch-up contribution will not count against the employers deduction limit under section 404, or against the individual's overall 415(c) dollar limit.
Modifications of Top Heavy Rules

A plan is generally considered "top heavy" if more than 60 percent of plan assets are held on behalf of "key employees." Due to the design of this test, top heavy rules essentially affect only small business. Key employees generally include officers earning over half the Section 415 defined benefit plan dollar limit ($70,000 in 2001), 5 percent owners, 1 percent owners earning over $150,000, and the 10 employees with the larges ownership interest in the business (as long as they earn more than $30,000). Further, family members of 5 percent owners are deemed to be key employees under family attribution rules.

Top heavy plans must meet a special vesting schedule and make minimum contributions to all non-key employees to the extent contributions are made on behalf of key employees.

A number of changes have been made here:

  • The definition of "key employee" is modified to delete the "top 10 owner" rule, provided that an employee will not be treated as a key employee based on his/her officer status unless the employee earns more that $130,000, and to eliminate the 4-year look-back rule for identifying "key employees."

  • Matching contributions will now count toward satisfying the top heavy minimums.

  • The matching contributions 401(k) plan safe harbor will be deemed to satisfy the top heavy rules. This does not mean that an accompanying profit sharing contribution automatically satisfies the top heavy rules, although the matching contributions will count toward otherwise satisfying the minimum.

  • The 5-year look-back rule applicable to distributions will be shortened to one year. However, the 5-year look-back rule will continue to apply to in-service distributions.

  • A frozen top heavy defined benefit plan will no longer be required to make minimum accruals on behalf of non-key employees.

 

Modification of Safe Harbor Relief for 401(k) Plan Hardship Withdrawals 401(k) plans generally must restrict distributions of amounts attributable to elective contributions. An exception to this restriction applies in the case of certain hardship distributions. Treasury regulations provide a safe harbor for determining whether a distribution qualifies as a hardship distribution. To qualify for this safe harbor, a participant receiving a hardship distribution must be prohibited from making elective contributions to the plan for the 12 months following the date of distribution. Treasury is directed to revise its safe harbor hardship distribution rules to reduce to 6 months the period of time participants must be prohibited from making additional elective contributions. Also, hardship withdrawals under the terms of the pan will not be treated as eligible rollover distributions.
Modifications to Limits on Retirement Plan Contributions and Benefits

Current law limits:

  • 401(a)(17): annual compensation taken into account limited to $170,000.

  • 402(g): elective deferrals limited to $10,500 per year.

  • 415(b): maximum annual benefits are the lesser of 100 percent of three-year high salary or $140,000 (or less for pre-65 retirees).

  • 415(c): maximum defined contribution plan contribution is the lesser of $35,000 or 25 percent of compensation.

  • 457(b): contribution limit is generally $8,500 per year.

  • SIMPLE: maximum elective deferral is $6,500 per year.

Beginning in 2002, the Act raises all of the significant dollar limits as follows:

  • 401(a)(17) compensation limit to $200,000; and then indexed in $5,000 increments.

  • 402(g) elective deferral limit to $11,000 in 2002; then increased $1,000 each year until $15,000 in 2006; and then indexed in $500 increments.

  • 415(b) annual benefit limit to $160,000; and then indexed in $5,000 increments. Note that this provision applies to years ending after December 31, 2001.

  • 415(b) annual benefit limit will no longer have to be reduced for retirements ages 62 through 65. Note that this provision applies to years ending after December 31, 2001.

  • 415(c) contribution limit to $40,000, and then indexed in $1,000 increments.

  • 457 elective deferral limit to $11,000 in 2000, then increased $1,000 each year until $15,000 in 2006; and then indexed in $500 increments.

  • SIMPLE elective deferral limit to $7,000 in 2002, then increased $1,000 each year until $10,000 in 2005; and then indexed in $500 increments.
Deduction Limits A sponsor of a profit sharing plan cannot deduct contributions to the plan in excess of 15 percent of aggregate employees' compensation. In the case of a stand-alone money purchase plan, the deduction limit is the minimum funding requirement for the plan. The deduction limit for profit sharing plans is increased to 25 percent of aggregate employees' compensation. Money purchase plans will be treated as profit sharing plans for purpose of the 404 deduction limit and thus will be subject to the 25 percent limit.
Increase in 25 Percent of Compensation Limitation Under Section 415(c), total annual contributions to a defined contribution plan may not exceed the lesser of 25 percent of compensation or $35,000. The 25 percent of compensation limitation has been increased to 100 percent of compensation. The dollar limitation will still apply. The provision also repeals the maximum exclusion allowance applicable to 403(b) plans.
Repeal of "Same Desk Rule" Under the "same desk rule," a distribution to a terminated employee is not allowed if the employee continues performing the same functions for a successor employer. The same desk rule applies to 401(k), 403(b) or 457 plans. The same desk rule is eliminated by replacing "separation from service" under Section 401(k)(2)(B) with "severance from employment." Conforming changes are also made for 403(b) and 457 plans. The provision applies to distributions are after December 31, 2001, regardless of when the severance from employment occurred.
Employers May Disregard Rollovers for purposes of Cash-Out Amounts Terminated participants' benefits may be cashed out if the non-forfeitable present value of such benefits does not exceed $5,000. A plan is permitted to ignore amounts attributable to rollover contributions when determining the cash-out amount.

 

 

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401k-Type Plans for One-Person Businesses: Introducing 401(k) Easy-For-One for only $495 per year complete plus a one-time only set-up charge of $795--complete!

I. Overview

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.

-- Broad spectrum of no-load investment options, and the option to use a self-directed discount brokerage account.

--A loan feature---it may come in handy in a family emergency.

--The ability to easily and affordably convert to a standard 401(k), should the business grow to include more employees.

Benefits of 401(k) Easy-For-One

* Affordable and complete, at only $495 per year.

* 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 401(k) Easy-For-One.

*Employer/owners have complete control over their 401(k) Easy-For-One investments, as do all 401(k) Easy Online users.

*Employer/owners have complete control over their 401(k) Easy-For-One investments, as do all 401(k) 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.

 

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