401(k) retirement plans are a popular employee benefit because employees can use the plans to put pre-tax compensation towards their retirement, maximizing their contributions. Employers may also match the funds employees contribute, further enhancing the advantages of a 401(k) plan.
One of the choices employers have if they decide to offer retirement benefits is a 401(k) plan. With a name referencing the Internal Revenue Code section they are established under, 401(k)s are defined contribution retirement plans that employees can use to have part of their pre-tax pay put into an interest-bearing account that will be held tax-free until the money is actually used, usually at retirement. In addition, employers may match the money employees contribute to a 401(k) plan with their contribution to the account, for example, dollar for dollar or with 50 cents on the dollar.
Basically, there are two types of 401(k) plans; bonus or profit-sharing plans and thrift plans:
- Bonus/profit sharing plans. Under a bonus plan, contributions are generally not made until the end of the year when a traditional bonus is declared for all employees. Each employee may then elect to receive the bonus or the declared profit-sharing distribution in cash or have the amount contributed to the plan. The plan may allow an employee to take the entire bonus or distribution amount as either a cash bonus or as a plan contribution. Alternately, the plan may allow the employees to take part of the distribution in cash and part as a plan contribution.
- Thrift plans. A thrift plan gives an employee the option of receiving a reduced salary (or foregoing a salary increase) and having the difference contributed to the plan. A fixed percentage of the employee's salary is then deducted from each paycheck and contributed to the plan on the employee's behalf. Generally, employees are given the additional option of changing their contribution levels once or twice a year. Many thrift plans provide for additional (matching) employer contributions.
Participation in a 401(k) plan has several tax advantages. First, the employer is generally permitted to take a tax deduction for its contributions to the plan when the contributions are made. In addition, the employee pays taxes only for employer contributions, or portions of contributions, when he or she receives them in cash after retirement or separation from employment.
401(k) plans are among the most popular retirement plans offered by small employers. If a 401(k) plan sounds like something you're interested in, you'll need to understand the general requirements of 401(k)s and what planning options are available with this type of plan.
401(k) plan requirements
There are certain requirements of 401(k) plans that you should be aware of when you consider offering one to your employees:
- There must be a written plan that is communicated to employees.
- The plan must be for the exclusive benefit of employees or their beneficiaries.
- The plan may not discriminate in favor of highly compensated employees. An employee is considered a highly compensated employee for a given year if, at any time in that year or the preceding year, the employee:
- was a five percent or more owner of the employer, or
- earned more than $115,000 for 2013 and 2014 (the amount may be adjusted annually for inflation) or was in the top 20 percent of employees in terms of compensation
- The maximum amount that an employee may voluntarily defer into the plan is $17,500 for 2013 and 2014 (this amount may be adjusted annually for inflation). Those that are age 50 or over in 2013 or 2014, can contribute an additional $5,500 for the year.
- Minimum vesting rules must be met. When an employee becomes vested in a retirement plan, it means that he or she has participated in a plan long enough or has provided enough years of service to an employer such that the employee becomes entitled not only to the contributions that the employee might have made but also to the contributions made by the employer. Generally speaking, employees must be completely vested after five years of service.
- An employee's entire interest in the plan must be paid out by April 1 of the year after the employee retires or reaches 70 1/2 years of age, whichever is later, or periodic payments must begin no later than April 1 of the year after the employee retires or reaches age 70 1/2 and must generally be paid over the lifetime of the employee.
- The plan must provide for a qualified joint and survivor annuity.
- The plan must contain a spendthrift provision.
- Reports must be filed with the IRS, the Department of Labor, and the Pension Benefit Guaranty Corporation, while other reports must be furnished to plan participants and their beneficiaries, under ERISA, the federal pension law.
- The plan will not qualify as a 401(k) plan if it requires that an employee have more than one year of service with the employer or employers maintaining the plan.
- The plan must provide a separate account for each participant and must separately account for contributions that are subject to the special vesting and distribution rules.
- Income, expenses, gains, losses, and forfeitures from other participants must be properly allocated to each plan participant's account, using a reasonable and consistent method of accounting.
In addition to these requirements, you should also address the planning options involved in offering 401(k) plans.
Planning options available with 401(k)s
Adopting a 401(k) plan represents a commitment by you that will affect your compensation policy for many years. This discussion is designed to get you thinking about some basic decisions and issues that you'll need to consider in planning a 401(k) plan.
To contribute or not to contribute? A plain-vanilla 401(k) plan that only provides for elective contributions from employees would cost you very little but would allow you to offer a plan for yourself and your employees to save and shelter income from tax. If you decide to contribute matching funds to the plan, however, it will obviously have a greater impact on your business's bottom line. A matching feature may increase employee participation, however.
Although a plan may finance contributions solely through salary reductions, a high employee contribution rate may create pressure on employers to provide salary increases to cover plan contributions. If you do decide that you want to match funds, you must then think about whether or not you'll be able to meet that ongoing financial obligation. Matching contributions are a cost that the employer cannot control once the matching formula is set because you cannot control how much employees contribute (though you can set an upper limit of a certain percentage of an employee's compensation, such as 5 or 10 percent).
Investment issues. Once the funds are in an account, they must be invested. This brings up another set of questions. Should employees be allowed to control the investment of their own accounts? Should they be given a few carefully considered investment alternatives? Should investment decisions be made by the plan administrator? While a broad range of investment options is one means of attracting more employee participation, it will also increase the complexity of plan administration.
Borrowing issues. Because funds in a 401(k) plan are subject to stringent restrictions on withdrawal, employees may be reluctant to tie up their money for a long period of time. Some plans allow employees to borrow against their money, with interest. Allowing employees to borrow from the plan may encourage employee participation, especially among low-paid employees. Of course, it means additional administrative time and cost.
Ease of administration characterizes SIMPLE plans
Employers with no more than 100 employees may set up a savings incentive match plan for employee (SIMPLE). In effect, SIMPLE plans trade off lower annual contribution limits for ease of administration. Thus, they're generally cheaper and easier to operate than other retirement options, but you can't save as much for retirement each year as you can with the other options. The funding mechanism for a SIMPLE can be either a 401(k) plan or an IRA.
The following are the basic rules that apply to SIMPLE plans:
- A SIMPLE must be the only retirement plan you offer.
- The employee may contribute up to $12,000 annually in 2013 and 2014 (this amount may be indexed annually for inflation). Those who are age 50 or over in 2013 or 2014, can contribute an additional $2,500 for the year.
- The employer must either match each participating employee's contribution up to three percent of the employee's pay or make an across-the-board two percent contribution for all eligible employees with at least $5,000 in annual compensation, regardless of whether they participate in the plan. In the IRA form, employers can elect to limit the match to a minimum of one percent of all eligible employees' compensation, but this election can only be made in two out of every five years.
- Employees vest immediately in all contributions made to their account, by themselves or the employer.
- In the IRA form, only employees that received at least $5,000 in annual compensation in the preceding two years and who are reasonably expected to receive this amount of compensation in the current calendar year are eligible to participate. In the 401(k) form, eligible employees are those who received at least $5,000 in compensation during the preceding year and who are reasonably expected to receive this amount of compensation during the year in question.
- In the IRA form, your plan is exempt from all nondiscrimination and top-heavy rules. In the 401(k) form, it is exempt from the special nondiscrimination rules and from the top-heavy rules, but it still must meet regular nondiscrimination and coverage rules.
- Employers may take a deduction for contributions to the employees' accounts.
- There are no reporting requirements imposed on the employer except for a single report to the government when the plan is created (employers do have to notify employees as to account balances, investment performance, etc.).
- A distribution to an employee during the first two years after the plan is created is subject to a 25 percent excise tax. After two years, distributions to anyone under age 59 1/2 are subject to a 10 percent excise tax.
- Upon separation from employment, distributions may be rolled over tax free to an IRA or to another SIMPLE plan. Distributions from the IRA form of SIMPLE accounts that an employee has participated in for at least two years can be rolled over into other types of retirement plans, such as employer qualified plans and deferred compensation plans of exempt employers, organizations and public schools.
One of the more interesting aspects of SIMPLE plans is that, although you must offer the plan to all eligible employees, you can still set up the plan even if none of your employees wants to participate. That is not true of other plans. Of course, there are strict rules and heavy fines for business owners who don't properly give employees the option of joining.
If you're interested in setting up a SIMPLE plan, contact anyone who might offer IRAs or 401(k) plans, such as banks, insurance companies, or investment houses.