- GENERAL DISCUSSION
- FEATURES TO THE EMPLOYEE
- ADVANTAGES AND DISADVANTAGES FOR THE EMPLOYER
- HARDSHIP WITHDRAWAL RULES
- 401(K) PLANS AT-A-GLANCE
- FORMS AND CHECKLISTS
- What is a 401(k) plan?
- How does a 401(k) plan work?
- What are the benefits?
- What is a salary reduction arrangement?
- What are the nondiscrimination rules?
- How do I know if my plan is discriminatory?
- Can employees take money out of a 401(k) plan prior to retirement?
- What are the hardship withdrawal rules?
- What funds are available for a hardship withdrawal?
- What are the tax consequences of a hardship withdrawal?
- Can a loan be taken from funds in a 401(k) plan?
- What are the advantages of a loan vs. a hardship withdrawal?
- What are the disadvantages of a loan agreement?
- Are there any limits on the amount that can be contributed to a 401(k) plan?
- What happens if you contribute more than the allowable amount?
Although the 401(k) plan has been in existence for over two decades—since 1978 when Congress added Section 401(k) to the Internal Revenue Code—it has only recently become popular and accepted as the retirement benefit of choice in many organizations. This type of plan is also referred to as a “cash or deferred arrangement” (CODA) because it gives employees a choice between receiving cash currently or deferring the amount and having it contributed to the plan. In addition, many employers often match employee contributions, up to a certain percentage of salary. The CODA has become one of the most popular forms of qualified plans among both large and small employers. This section contains an overview of 401(k) plans—considerations, implementation, design, maintenance, and compliance.
A 401(k) plan permits employees to choose to defer a portion of their wages on a pretax basis. The 401(k) plan must be part of a qualified profit-sharing plan, a stock bonus plan, a pre-ERISA money purchase pension plan, or a rural cooperative plan.
The ability of the employer to “match contributions” has generated interest in the plan at all employee levels. This is important because 401(k) plans include strict nondiscrimination tests that require lower paid employees to defer compensation under the plan, in proportion to highly paid employees—in accordance with one of several formulas outlined below. The minimum level of deferral for lower paid employees is determined under a statutory formula based on utilization of the plan by highly compensated employees.
The major benefit to employees is that they are not taxed currently on the portion of compensation that is placed in the plan. An employee has the option of choosing between cash or future benefits on a year-to-year basis. This protects an employee when faced with unexpected immediate financial needs.
A 401(k) plan is a qualified defined contribution plan. This means that an employee can elect to defer allocations. The contributions enjoy tax-free reinvestment of earnings and the opportunity to receive special tax treatment on certain plan distributions.
A 401(k) plan frequently features an “employer matching” provision in which the employer makes a contribution to the plan equal to (a certain percentage of) the employee’s contribution. This serves to encourage participation among employees at all levels.
Another major benefit—in addition to the tax deferral—is that a 401(k) plan is eligible for five-year averaging on distributions. But, if an early distribution is taken, the amount is subject to an additional 10 percent tax.
Strict discrimination rules affect the qualification of pension plans. These rules focus on highly compensated employees and are described below. They require that a business stimulate as much participation as possible, particularly from lower-level employees, in order to avoid violating the rules and jeopardizing the qualification of the plan.
Because a 401(k) plan is a qualified plan, it is subject to the same rules imposed by the Internal Revenue Code and ERISA as are all other qualified plans. Therefore, it must be part of a definite written plan that is communicated to employees and established solely for the benefit of employees or their beneficiaries. A 401(k) plan must also meet these requirements:
Reporting Elective Deferrals To Employees
Employers must report, to their employees, the amount of elective deferrals made during the year. This is done on Form W-2. The report must be filed on or before the due date for providing the Form W-2.
A 401(k) plan must meet certain nondiscrimination tests to ensure that highly compensated employees cannot elect to defer a disproportionately higher amount of their salary than the non-highly compensated employees are deferring. If the 401(k) plan does not meet these special nondiscrimination requirements, it may be disqualified.
One of the benefits of a 401(k) plan versus other plans is the ability to make a hardship withdrawal under specific circumstances.
A hardship distribution is limited to an employee’s total elective contributions as of the date of distribution, reduced by any amounts previously taken for hardship.
Hardship withdrawals are subject to normal taxation of plan distributions and may be subject to a 10 percent tax for premature withdrawals.
A 401(k) plan can also make funds available to participants by loan in a broader way since a loan is not subject to the “hardship rules.”
Loans are not taxable to the employee provided the loan repayments are made when they are due.
A loan option, however, places additional administrative work on the employer. The loan agreements may not be discriminatory. And, the employer has the additional burden of dealing with defaults.
- A 401(k) plan provides an opportunity to contribute pretax dollars to a plan.
- A 401(k) plan must meet certain nondiscrimination tests.
- A 401(k) plan offers both benefits and drawbacks to the employer.
- Employees may withdraw money from a 401(k) plan prior to retirement, subject to certain conditions and limitations.
- There may be adverse tax consequences to taking an early withdrawal from the plan.
- As an alternative to a hardship withdrawal, an employee may wish to consider taking a loan from the plan.
- There are annual limits on the amount that can be contributed to a 401(k) plan.
- Click to see the new funding limits here.