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How a 401K Plan Works

Named after the tax law provision authorizing such plans, a 401(k) plan is a tax-favored arrangement that allows employees to regularly set aside a portion of their compensation in a retirement plan for their benefit. Participants are given their own individual investment accounts. They typically are permitted to direct the investment of their plan contributions (and any employer contributions) in one or more of the investment options offered by their plan.

All amounts that are paid into the plan, as well as all plan earnings on contributions, grow tax-deferred until the participant receives them at retirement. Since income taxes are deferred, plan assets can grow and compound at a substantially higher rate than comparable taxable investments.

 Employees elect the percentage of pay they wish to contribute to the plan, within certain limits. For 2005, no more than $210,000 of compensation can be counted in determining contributions and an employee can defer no more than $14,000 of pay, or $18,000 for individuals age 50 and over.  These figures will be adjusted for future inflation. 

Employers can make contributions according to a formula set out in the written plan. But no specific retirement benefit is promised. Rather, the eventual retirement benefits due to a participant depend on the amount of contributions made over the years and on how well the plan's investments perform.

In general, participants become eligible to begin taking distributions when they reach age 59-1/2. Nonetheless, there are several circumstances under which participants can make withdrawals before they reach retirement age. Death, disability, or termination of employment are three of the situations which will justify the distribution of funds. Employers also can add plan provisions for hardship distributions and loans. These options are discussed in the next section.

A 401(k) Plan Offers Unparalleled Flexibility

Employers and employees enjoy several attractive benefits as a result of participating in a 401(k) plan. The primary benefit for employers is the high degree of flexibility inherent in the structure and operation of a 401(k) plan. An employer may have the ability to not only provide a cost-effective employee benefit but also, at the same time, maximize benefits for the owners and other highly compensated individuals.

·         Employer Match: You can choose to match a percentage of your employees' contributions if you wish - or not. The match is typically used as an incentive to encourage contributions by employees. It is worth noting that numerous employer surveys have shown that as little as a 20% employer match for every dollar contributed substantially increases participation levels.

·         Profit-Sharing Combination: A 401(k) profit-sharing plan combines two of the most popular retirement plan options available. With a profit-sharing plan, you, as the employer, make contributions, which are generally (though they do not have to be) based on the profits of your business. You can contribute and deduct up to 25% of eligible employees' payroll to the plan. (Profit sharing and matching contributions are combined and count toward the 25% limit.)

If your company realizes little or no profits in a particular year, you do not have to make contributions to the plan since profit-sharing and matching contributions are typically discretionary. Contributions may be adjusted, depending on your own determination of your business's ability to make contributions. The 401(k) profit-sharing plan allows you to deduct all contributions up to the tax law's limits in the year they are placed in the plan. Moreover, none of the profit-sharing and employer matching contributions are subject to federal income tax withholding, Social Security, or federal unemployment taxes.

 ·         Loan Option: You can offer a plan loan option if you wish. Loans are not taxable to employees as long as they are repaid on time. If you do not want your employees dipping into their retirement plan accounts, then you simply opt not to offer the loan option in your plan.

 ·         Hardship Distribution Option: A 401(k) plan may allow participants to take distributions in the event of financial "hardship." A hardship might include an event such as buying a principal residence or paying for medical expenses or a child's college tuition. Hardship distributions are taxable to employees and may be subject to a 10% excise tax if the employee is under age 59-1/2.

·         Flexible Vesting Arrangements: You have some flexibility in deciding on how long you require employees to work for your business before they become fully entitled to (or vested in) employer contributions (matching and profit-sharing contributions). However, tax law limits apply. It is not uncommon to provide full entitlement over six years. With a six-year vesting schedule, your employees would be entitled to 20% of employer contributions with two years of service, 40% with three years, 60% with four years, and so on.

·         Choice in Number of Investment Options: You can choose the investment options your plan will offer. Employers that want to satisfy the protection-from-liability provisions of ERISA Section 404(c) must provide a "broad range of investment alternatives" - generally at least three core investment choices. Each must be diversified and have materially different risk and return characteristics, among other requirements. 

·         Choice of Administrative Structure: You have a number of choices when it comes to the administration of your plan. One-stop shopping for all plan services is not the only way to go, nor is it necessarily the best way. Many employers choose an independent plan administrator to design a plan that meets their specific objectives and to handle the numerous details of plan administration and consulting.

 The Basic Requirements

There are participation and special nondiscrimination rules that 401(k) plans must meet if they are to retain their tax-qualified status.

·         You must provide a written plan, which specifies who may participate and how contributions will be allocated among employees.

 ·         You cannot deny participation to eligible employees age 21 or over who have at least one year of service.

 ·         Employee contributions are always 100% vested.

 ·         Your plan may not discriminate in favor of highly compensated employees (HCEs). An HCE is an employee who: (1) was a 5% owner of the employer at any time during the current year or preceding year or (2) had compensation of more than $95,000 for the preceding year (indexed for inflation) and, if the employer should so elect, was in the top 20% of employees by compensation for the year.

In general, the average percentage of pay contributed by HCEs can only be 2% higher than the average percentage contributed by all nonhighly compensated employees (NHCEs) eligible to contribute. Thus, HCEs are limited in how much salary they can contribute each year based on the level at which the NHCE group is participating in the plan. Every eligible NHCE who decides not to participate pulls down the average deferral rate for the NHCEs, which in turn will limit the average deferral rate for the HCEs. This is one reason why encouraging NHCEs to participate is so important to a plan's success. Special annual testing (commonly referred to as the ADP/ACP test) is required to ensure compliance with the nondiscrimination rules.

 Safe Harbor Design

The law offers employers methods that can help them more easily satisfy the nondiscrimination requirements. The Small Business Job Protection Act of 1996 simplifies plan administration by giving the employer the choice of performing the special 401(k) nondiscrimination tests using data for NHCEs for the preceding or current year. Formerly, only current year data could be used. This resulted in a plan having to be regularly tested during the year to ensure compliance with the rules. With the use of data from the preceding year, compliance may be easier. Note that in the first year of a plan, employers can assume a 3% deferral rate by NHCEs, in general allowing HCEs to defer on average 5% of pay.

In addition, the law also provides special "safe harbor" methods for satisfying the nondiscrimination rules. Plans that use a safe harbor need not otherwise pass the special tests. By adopting a safe harbor design, an employer can allow HCEs to contribute the maximum deferral (currently $14,000, or $18,000 for individuals age 50 or older) without regard to how much the NHCEs contribute.

Essentially, to qualify under the safe harbor, the employer must make: (1) a nonforfeitable profit-sharing contribution equal to 3% of pay or (2) a nonforfeitable matching contribution for each NHCE equal to 100% of the first 3% of the compensation deferred and 50% of the next 2% of compensation deferred. Several other rules apply. If you are already making a matching or profit-sharing contribution, it may be advisable to consider a safe harbor design.

 Another type of safe harbor provision permits an employer to apply the ADP/ACP tests by ignoring NHCEs who are eligible but who have not completed a year of service or reached age 21. Since these NHCEs will have no impact on the amount HCEs can contribute, it is becoming more common for plans to allow employees to start contributing immediately upon beginning work. The immediate participation is a more attractive employee benefit that will not necessarily increase employer costs since the one year wait and age 21 requirement may remain in place for purposes of matching and profit-sharing contributions.

 401(k) SIMPLE Plans

A 1996 tax law introduced a new retirement plan for small businesses called the Savings Incentive Match Plan for Employees (SIMPLE). Only employers that offer no other plan and that have 100 or fewer employees earning at least $5,000 in compensation during the previous year can offer a SIMPLE Plan. SIMPLE Plans can be structured either as an Individual Retirement Account (IRA) for each employee or as a 401(k) salary deferral plan. 

The Main Features of a SIMPLE 401(k) Plan 

Like a regular 401(k) plan, a SIMPLE 401(k) plan permits employees to defer pay. Unlike standard 401(k) plans, a SIMPLE plan limits the maximum annual employee contribution to $10,000 of pay, or $12,000 for individuals age 50 or older. The employer generally is required to match employee elective contributions dollar for dollar up to 3% or contribute an automatic 2% of salary for all eligible employees. 

SIMPLE 401(k) Plans Deliver Many Benefits to an Employer 

SIMPLE plans do not present the same array of testing and administrative requirements that are sometimes faced by employers with the standard 401(k) plan. For example, a SIMPLE Plan:

 ·         Does not have to undergo the special nondiscrimination tests for 401(k) plans and is not subject to the tax law's top-heavy rules;

 ·         Is not subject to the 401(k) plan participation and vesting requirements; and

 ·         Allows a two-year grace period for employers that outgrow the 100-employee limit.

 There Are Drawbacks to SIMPLE Plans

Employers should be aware that SIMPLE plans might not be appropriate for every small business. Since they require an employer contribution, they have a built-in, ongoing cost to the employer. They also require immediate vesting in all company contributions for all qualified employees. Moreover, lower employee deferral limits apply for employee contributions, compared to standard 401(k) plans. Additionally, income taxes must be paid on early withdrawals and a special early withdrawal penalty of 25% is imposed, compared to the typical 10% penalty for standard 401(k) plans. Finally, once an employer introduces a SIMPLE Plan into the workplace, the employer's ability to introduce any other type of plan is restricted.

 The Importance of Link-Ups

Participants are more sophisticated now than ever before. They want easier access to plan information. They want to be able to check plan balances and make changes in their investment accounts at any time. 

This participant insistence on more comprehensive options and capabilities puts pressure on plan sponsors to find an administrator who can deliver these services - and more. Traditionally, plan sponsors have turned to one service provider for all their plan-related services. However, many plan sponsors have found that a one-size-fits-all, turnkey approach is not always the best strategy. For example, a plan sponsor may be satisfied with the investment management skills of its plan provider but be less than happy with the provider's ability to provide meaningful consulting and deliver superior administrative services. Unfortunately, the plan sponsor who receives a bundled package of plan services has to take the good with the bad.

As a plan sponsor, the question you have to ask is whether an investment company or another financial institution is the best place to secure the kind of ongoing pension and tax advice you require to keep your plan on the right track and out of costly compliance trouble.

Many plan sponsors have found that it makes sense to choose the strongest provider in each area of plan services. Thus, an investment manager is chosen to manage plan investments and a separate third-party administrator is selected to handle the full range of administrative services. 

It makes sense to work with a plan administrator who will delve into the details of the tax and pension laws and of your specific situation to uncover the strategies that make the most sense for your business. Moreover, you want your plan administrator to have the experience and the technical know-how to ensure cutting-edge services, regular - and easy - access to plan information, and compliance with the complexities of the pension and tax laws. The logical choice to handle these tasks and achieve these objectives is an experienced third-party administrator, such as our organization.

 Conclusion

Introducing a 401(k) plan into your workplace is a serious undertaking. It requires effort and a great deal of thought in order to meet specific business objectives. A 401(k) plan is, nonetheless, one of the most flexible and attractive employee benefits. Talk to one of our experienced employee benefits professionals if you are still undecided on whether a 401(k) plan makes sense for you.