401(k) Overview

• Terminology
• Plan Types
  • Defined Contribution Plans
  • Defined Benefit Plans
  • Individual Retirement Accounts
  • Non-Qualified Retirement Plans
• Sample 401(k) Plan Outline
• Qualified Plan Limitations
  

The 401(k) plan is the most popular and fastest growing type of retirement plan in our country today. This type of plan is technically a provision that can be added to a Defined Contribution Retirement plan, such as a Profit Sharing or Stock Bonus plan. It is named after section 401(k) of the Internal Revenue Code, which permits employees of qualifying companies to invest some of their own money to the plan. By making this change to the Internal Revenue Code in 1978, the federal government opened the door to a popular and efficient type of retirement plan that will affect almost every American worker. Today, more than a trillion dollars ($1,000,000,000) are invested in 401(k) retirement plans - from $0 just 20+ years ago. It's no overstatement to say... "The 401(k) plan is the most important national retirement effort since Social Security was introduced in the 1930's."

Terminology

Employee Matching Contributions:

Employee contributions to a 401(k) plan are known as "deferrals" because employees invest into the plan prior to paying federal income taxes, therefore "deferring" the tax until retirement. Although employees can withdraw the money for certain emergencies know as "financial hardships" or, in some cases, borrow against their investment, the money is intended to stay in the plan until employees are at least the age of 59 1/2. These contributions are typically invested through payroll deduction and become a function of payroll administration by the employer. Employee deferrals are typically through the employees to various investment options made available by the employer's plan Provider. (Please note: section 404(c) of the IRS codes give some limited liability protection to the employer if the employer gives employees investment control and at least three distinctly different types of investment options, and the ability to change them at least quarterly). While the investment is growing in the 401(k) account, employees do not pay any taxes on it. When they withdraw the money at retirement, employees will pay taxes at their ordinary income tax rate at that time.

The maximum employee deferral limit is 15% of gross pay or $13,000, whichever comes first. Deferrals plus optional employer profit sharing and matching contributions cannot exceed the lesser of 100% of employee's compensation or $40,000.

Some employers also contribute to a 401(k) plan. This contribution is called an employer matching contribution. Typically the employer matches a certain percentage of the employee contribution, up to a dollar amount or percentage limit (i.e.: the employer puts in 25 cents for every dollar, up to the first 6% of annual pay the employee defers). Not every employer matches the employee contribution, but in some cases the company will match the employee contribution dollar-for-dollar. These employer contributions are considered a tax-deductible business expense and grow on a tax-deferred basis.

Some employers also make an additional contribution at plan-year end in the form of increased matching contributions and/or a profit sharing contribution. These employer contributions are considered a tax-deductible business expense and also grow on a tax-deferred basis. More information regarding these types of discretionary contributions and the various allocation methods is in "Qualified Retirement Plans" available on our Web site.

The annual maximum employer contribution (matching contributions + discretionary contributions) to the plan cannot exceed 15% of eligible compensation.

Within federally imposed guidelines, the employer gets to select which employees are eligible to participate in the 401(k) plan. Eligibility requirements usually consist of length of employment, age, and number of hours required to work before becoming eligible.

Qualified Retirement Plans

Qualified retirement plans are Congressionally approved employee benefit plans that meet the stringent requirements of section 401(a) of the Internal Revenue Service (IRS) Code and the Employees Retirement Income Security Act (ERISA) of 1974. Qualified retirement plans provide several major tax benefits such as the following:

· Employer contributions can be deducted for income tax purposes.

· Employee contributions are deferred from current income taxes.

· The earnings on plan assets accumulate on a tax-deferred basis.

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Plan Types

What is The "Right" Type of Plan?

Three Principal Types of Plans:

Defined Contribution Plans generally require the employer to put a percentage of current eligible employee salaries into the plan each year. The amount of retirement benefit will depend on the amount contributed, investment performance and number of years until the participant retires. The investment risk usually rests on the employee.

Defined Benefit Plans pre-determine the benefit amount each participant will receive at retirement age, typically based on salary and/or years of service with the company. It is the employer's responsibility to estimate how much must be contributed each year to accumulate the necessary funds to pay out the promised retirement benefits. Interest rates, ages of eligible employees, length of service, etc., will have an effect on the calculation. An actuary usually calculates the amount of the employer contribution. All the investment risk rests on the employer.

Tax-Deferred Individual Plans or IRA based retirement plans are owned exclusively by individuals and are therefore not technically considered "Qualified" retirement plans. However, no discussion of employer sponsored retirement plans is complete without consideration of the SEP-IRA (Simplified Employee Pension) and the SIMPLE-IRA (Savings Incentive Matching Plan for Employees).

Summary of Plan Types:

Defined Contribution Plans

Target Benefit Plans: These plans have elements of both the defined benefit and defined contribution plans. The benefits are determined as if the plan were a defined benefit plan, while the defined contribution annual contribution percentage (25%) and dollars amount ($30,000) limitations apply to the actual contribution.

Traditional Profit Sharing Plan: Similar to the money purchase plan, except that contributions do not need to be a fixed percentage and they do not need to be made every year. The maximum employer contribution limit is 15% of payroll. The maximum annual employee benefit is the lesser of 25% of annual pay or $30,000.

Integrated Profit Sharing & Money Purchase Plans: These plans allow a higher allocation of the contributions to those employees being discriminated against by some other employer or government sponsored retirement plan such as social security. These plans favor more highly compensated employees, particularly those that earn in excess of the maximum taxable wage base (i.e. $85,000 in 2003). The maximum employer contribution limits and maximum annual employee benefit limits apply.

Age-weighted or (WAVE) Money Purchase & Profit Sharing Plans: These plans allocate employer contributions based on age in an attempt to provide an assumed equivalent retirement benefit at normal retirement age. Unlike a typical profit-sharing plan in which each participant receives a contribution based on compensation, employees in age-weighted profit-sharing plans have an age factor applied to the profit-sharing plan allocation formula in order to compensate older employees who have fewer years to accumulate sufficient funds for retirement. At first glance, this type of formula might appear to violate nondiscrimination regulations, since it permits larger contributions for older employees, who tend to receive higher compensation. However, under the regulations, these contributions can be converted to "equivalent benefits" and can pass the general nondiscrimination test. Since annual allocations are projected to retirement age with interest, they will vary according to the plan participants ages. All of the basic requirements that apply to regular profit-sharing plans also apply to age-weighted profit-sharing plans.

Cross-Tested or New Comparability Money Purchase & Profit Sharing Plans: These plans divide employees into separate and distinct allocation groups in order to provide larger percentage contributions for certain select employees than for other employees. (In some cases, as much as 80 percent or 90 percent of the employer's contribution can be allocated to the select group.) Unlike an age-weighted profit-sharing plan, a new comparability plan does not necessarily relate the amount of the contribution to the employee's age. However, age spreads among the allocation groups have an impact. By using the allocation group technique, a plan can be designed to provide one contribution rate to a select group of employees, with a different and much lower rate for employees who are not in the select group(s).

The allocation groups may be based on any reasonable criteria, including percentage of ownership, status as key or highly compensated employee, job description, length of service, age, etc. The allocation groups can be tailored to satisfy specific objectives since they can be set up for owners, officers, supervisors, managers, long-service employees, or salaried employees. The structure of the allocation groups must be defined in the plan document and may be changed periodically by plan amendment. Each allocation group has its own allocation method. Within each allocation group, the contribution is allocated uniformly (either as a flat dollar amount or as a percentage of pay). The annual allocation method must also be defined in the plan document and may be changed by plan amendment, provided no individual's accrued benefit is reduced. New comparability plans usually require annual testing and are very sensitive to employee demographics.

Stock Bonus Plan: Similar to the traditional profit sharing plan. The plan may, but is not required to, invest primarily in the employer's company stock. The maximum employer contribution limit is 15% of payroll. The maximum annual employee benefit is the lessor of 25% of annual pay or $30,000.

401(k) Plan: Also called a cash or deferral plan, this plan is a stock bonus or profit sharing plan provision which can be added to allow employees to participate by contributing their own salary or bonus on a pre-tax basis to the plan. The employee maximum deferral limit is the lessor of 15% of gross pay or $13,000 (2004). The employer may encourage participation with a match of up to 100% of what the employee defers. Please note: additional nondiscrimination tests will apply which may limit the contribution rate for highly compensated employees.

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Defined Benefit Plans

Flat-Benefit Formulas: These formulas pay a flat dollar amount for each year of service recognized under the plan.

Career-Average Formulas: There are two types of career-average formulas. Under the first type, participants earn a percentage of the pay recognized for plan purposes in each year they are plan participants. The second type of career-average formula averages the participant's yearly earnings over the period of plan participation. At retirement, the benefit equals a percentage of the career-average pay, multiplied by the participant's number of years of service.

Final-Pay Formulas: These plans base benefits on average earnings during a specified number of years at the end of a participant's career; this is presumably the time when earnings are highest. The benefit equals a percentage of the participant's final average earnings, multiplied by the number of years of service. This formula provides pre-retirement inflation protection to the participant but can represent a higher cost to the employer.

Flat-benefit formulas are common in collectively bargained plans or plans covering hourly paid employees. Career-average and final-pay formulas are most common in plans covering non-union employees. Under pay-related formulas, an employer has some discretion in defining pay for plan purposes provided the definition does not discriminate in favor of highly compensated employees, subject to the statutory and regulatory definition of compensation used in testing for nondiscrimination. Under ERISA's minimum standards, there is also some leeway in determining what employment period will be recognized in the benefit formula. The benefit may reflect only the plan participation period or may be based on the entire employment period.

In a Defined Benefit Plan the maximum employer contribution limit is 25% of payroll. The maximum annual employee benefit is the lessor of 100% of annual pay or $130,000. Please note: the higher contribution limits may allow older more highly compensated business owners to obtain significant retirement benefits.

Individual Retirement Accounts

SEP-IRA or "Simplified Employee Pension": A SEP is a group of individual "IRAs" to which an employer may contribute more than a traditional IRA or Roth IRA on behalf of the eligible employee. Since the SEP is not technically a "qualified plan" it does not require Plan & Trust Agreements or require the employer to file 5500 tax forms annually, therefore, the administrative costs are minimal. Unlike qualified plans they do not offer loans, vesting or the exclusion of part-time employees. The employer must employ less than 25 employees and the maximum employer contribution limit is 15% of payroll. The maximum annual employee benefit is the lessor of 15% of annual pay or $25,500.

SIMPLE-IRA or "Savings Incentive Matching Plan for Employees": The Simple retirement plan can be established by an eligible employer who employs 100 or fewer employees who earned at least $5,000 in compensation during the two preceding years and is expected to receive $5,000 during the current year. The Simple Plan must be the only plan offered by the employer, 100% vest all contributions immediately. The employee has the option to defer the lessor of 100% of salary or $8,000 (2003). The employer must either match the participant deferral up to 3% of compensation, or make a 2% of compensation non-elective contribution to each eligible employee, regardless of whether or not they elect to defer any of their own compensation. Please note; these plans do not require the nondiscrimination tests applicable to qualified retirement plans

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Non-Qualified Retirement Plans

· Deferred Compensation Plans
· Supplemental Executive Retirement Plans (SERPS)
· Executive Bonus Plans

These plans give the employer the ability to be more selective as to which employees actually participate in the plan. Please feel free to contact our office if you have an interest in learning how these unique employee benefit plans would work for your organization.

Vesting Schedule:

The employer designs the applicable vesting schedule used in the plan. Vesting can be viewed as "ownership" in plan assets. Employees are always 100% vested in their deferral contributions plus investment earnings. Employer contributions usually have shared ownership between the employer & employee based on years of service with the company referred to as a vesting schedule. Two common forms of vesting schedules are known as Graded Vesting and Cliff vesting. Graded vesting schedules gradually give the employee more ownership in the employer contributions and can stretch out as long as 7 years. Cliff vesting arrangements can been seen as an all or nothing arrangement where employee receives no ownership in employer contributions until a specific time period has elapsed. This form of vesting can only be as long as five years See example below:

Investment Options:

Employer determines the number of investment options available in the plan. Typically the employees determine how to allocate his investments among the various options available. The most common investment options include the following:

Discrimination Testing Requirements:

• Actual Deferral Percentage (ADP) Test & Actual Contribution Percentage (ACP) test
• Top Heavy Test

Employer Advantages:

• Helps Attract and Retain Employees
• Helps Employees Build Their Own Retirement Fund
• Lower Cost Than Defined Benefit Plans

Employee Advantages:

• Pre-Tax Investing
• Tax-Deferred Growth
• Convenient Payroll Deduction
• Professional Money Management