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A 401(k) Plan is a unique type of employee benefit plan,
with special characteristics which make it enormously popular
with both employees and employers. It is the benefit plan
that allows employees to defer salary today to save for retirement
on a tax deferred basis.
Employers like 401(k) plans because they are flexible and cost-effective.
The employee's deferrals and any employer contributions are
tax-deductible for the employer and are not included in the
employee's gross income, though they are subject to payroll
(FICA & FUTA) taxes.
401(k) plans derive their name from Internal Revenue Code Section
401(k), under which these types of plans are established and
regulated. Because a 401(k) plan allows employees to choose
between cash and deferral of income, it is also known as a
cash or deferral arrangement or CODA.
A 401(k) plan can be either a stand alone plan or an additional
feature of a profit sharing or stock bonus plan. Any type
of business can establish a 401(k), including corporations (both
C and S corporations), partnerships, sole proprietorships,
limited liability corporations and professional practices.
- The maximum annual tax-deductible contribution for the
employer to a 401(k) plan is 15% of participants' compensation.
- The maximum annual allocation to an individual participant
is the lesser of 25% of compensation or $40,000.
- The maximum annual salary deferral by a participant is
the lesser of 20% of gross pay or $11,000 (indexed for 2002).
- Minimum contribution to top-heavy plan is 3% of pay for
all participants who are not key employees or at least as
high a percentage as key employees receive.
- Additional contributions can be made in the form of profit
sharing contributions on a discretionary basis.
1. Key employee - means an employee who, at any time
during the plan year or any of the four preceding plan years,
is:
- a 5% owner
- a 1% owner whose annual compensation exceeds $200,000
- one of the 10 largest owners of the employer having annual
compensation in excess of the annual addition limitation
2. Highly Compensated Employees - (HCE)
- At any time during the current or preceding year owned,
directly or indirectly, more than 5% of the employer (a
5% owner); or
- Received compensation from the employer of more than $85,000
(indexed for 2001) in the preceding year.
3. Non-Highly Compensated Employees (NHCE) - not highly
compensated employees.
4. A Top-Heavy Plan - is a plan that unduly favors
key employees by providing 60 percent or more of the benefits
or account balances to these employees. These plans are subject
to additional restrictions.
A 401(k) plan must be reviewed at least annually to be sure
that the highly compensated employees are not deferring a
substantially greater percentage of their compensation than
the non-highly compensated employees.
The ADP test checks the amount deferred, on average, by each
group. The average deferral percentage, or ADP, of the group
of highly compensated employees can not exceed on average
more than 2% more than the ADP of the non-highly compensated
employees.
An additional test, similar to the ADP test and called the
average contribution percentage or ACP test, must also be
satisfied if there are employer matching or employee after-tax
contributions, and may further limit contributions for the
highly compensated employees.
Because it is critical that a 401(k) plan meet these and other
nondiscrimination requirements, and because the calculations
can be quite complex, it is important that your 401(k) plans
be supported by skilled administration specialists.
Maximum eligibility requirements - Employees who are
age 21 or older and have completed one year of service with
the employer must be eligible to participate.
Maximum deferral - Individual participants can defer
as much as $7,000 (indexed) per year.
Vesting - Participant's deferrals and employer matching
or nonelective contributions are 100% vested.
HCEs and NHCEs - The deferrals of highly compensated
employees are not limited by the deferrals of the non-highly
compensated group.
Maximum tax-deductible Contributions - The maximum
annual tax-deductible contribution, including employee elective
deferrals, is 15% of the pay of all participants.
Required contributions - The employer must either
match employee's deferrals dollar for dollar up to 3% of pay,
or contribute 2% of pay for all eligible.
Maximum annual additions - The maximum annual addition
to a participant's account is the lesser of $40,000 or 25%
of compensation. The practical dollar limit for 2002 is the
$7,000 deferral maximum plus an employer match of $6,000 (3%
of the $200,000 compensation limit) = $13,000.
ADP Top-heavy requirements - Not subject to annual
ADP testing or top-heavy requirements.
Loans and Hardship withdrawals - May provide for participant
loans and hardship withdrawals.
Other Plans - An employer may not
operate any other qualified plan which benefits any employee
eligible to participate in the SIMPLE 401(k) plan.
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