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Cash or Deferred Arrangements
In simple terms, the 401(k) Plan allows an employee to choose between receiving his full salary in cash or having a portion of it deferred to a tax sheltered, interest bearing retirement plan. the money contributed to the plan is not reported for income tax purposes.
This type plan is extremely attractive in light of the potential non-deductibility of I.R.A. contributions. Even though many employees may not be able to make a tax-deductible contribution to an I.R.A., they may make the same type of contribution to the 401(k) Plan and receive the same tax benefits. Furthermore, they may contribute up to $15,500 and up to $20,500 if they are age 50 or older in the current calendar year.
Plan Provisions
Background
All profit sharing plans must have a definitely determinable allocation method. That is, the method used to allocate contributions to the individual participants must be specified in the plan document. There are various methods available to allocate the contributions. The benefit provided at normal retirement age is an account balance. There is no guarantee of benefits at normal retirement.
Type of Plan
Technically, a 401(k) Plan is usually a form of a profit sharing plan, though it could be a stock bonus plan. Because it is usually a profit sharing plan, contributions to plans for plan years beginning before January 1, 1986 were dependent upon current or accumulated profits. However, the Tax Reform Act of 1986 changed this requirement so that contributions for plan years beginning after December 31, 1985 need not be limited to current or accumulated profits.
General Anti-Discrimination Tests
A qualified plan must "benefit" at least 70% of all non-highly compensated employees. In the case of a 401(k) Plan, an employee who is eligible to make contributions will be treated as "benefiting" under the plan.
Special Test
The special non-discrimination tests limit elective deferrals by highly compensated employees based on the relationship of the " actual deferral percentage " for the group of highly compensated employees to the "actual deferral percentage" for non-highly compensated employees.
The "actual deferral percentage" for a group of employees is the sum of the "deferral percentages" for the employees in the group, divided by the number of employees in the group.
The "deferral percentage" for an employee is the percentage of that employee's compensation that has been electively deferred for the year. Eligible employees who makes no deferrals during the year have a zero deferral percentage. For employees who are a participant in two or more cash or deferred arrangements, the deferral percentage is the sum of elective deferrals made under all such arrangements, expressed as a percentage of the employee's compensation.
The following chart indicates the permitted disparity between the Average Deferral Percentage (ADP) for the non-highly compensated versus the Average Deferral Percentage for the highly compensated.
ADP for Non-Highly Compensated Employees |
Maximum ADP for Highly Compensated Employees |
0-2% |
2 times |
| 2%-8% | plus 2% |
| above 8% | 1.25 times |
This test is applied separately to employee deferrals and employer matching contributions.
The maximum Annual compensation that may be considered is $230,000, and the maximum amount that may be contributed to any participant's account is $46,000 plus any catch-up amounts.
Safe Harbor 401(k)
One of the newer versions of the 401(k) style plan is the Safe-Harbor plan. Under this plan an employer may exchange a guaranteed contribution in the form of a matching or profit sharing contribution and waived vesting in exchange for no ADP and/or ACP testing. This plan design has proven valuable to smaller employers who have family or key employees who wish to defer the maximum, but have problems with their annual testing requirements.