SECTION 401(k) PLANS

THE BASICS: Any profit sharing or Stock Bonus Plan which meets certain participation requirements of IRC Sec. 401(k) can be a cash or deferred plan. An employee can agree to a salary reduction or to defer a bonus which he or she has coming.

HOW IT WORKS

	Employee has option of taking cash or having it paid to the trust for retirement. This is equivalent to an employee tax deductible contribution. (Except Social Security and unemployment taxes.)
	Any additional employer contributions are tax deductible. IRC Sec. 404(a).
	Employer contributions, if any, are not taxed currently to the employee. IRC Sec. 402(a) and 403(a)
	Earnings accumulate income tax-deferred. IRC Sec. 501(a).

TWO TYPES OF PLANS

SALARY REDUCTION. An employee can agree to a salary reduction; e.g., 10% of compensation, which the employer can then pay to the Retirement Plan Trust. It is deductible to the employer, but is not included in the employee's gross income. (This is clearly the most common type of plan.) However, employee deferrals are subject to FICA and FUTA. In addition, an individual who participates in the 401(k) plan and who has attained age 50 by the end of the plan year, will be able to make additional elective contributions to the plan for that plan year.

CASH OR DEFERRED. The employer can decide to pay a bonus and give the employees the following choices: a. Take it as cash. b. Defer it to the trust. c. Take part and defer the rest.

ADDITIONAL CONSIDERATIONS

	1. MAXIMUM ANNUAL CONTRIBUTION. Up to 25% of covered payroll can be contributed by a combination of employee and employer contributions. Individual participants may be able to exceed these limits under some circumstances and have allocated up to 100% of compensation. In no event may the dollar amount exceed $46,000 from the combination of employer and employee contributions.
	2. INDIVIDUAL LIMITS (2008). The allocation total of contributions and employee deferrals to a participant's account may not exceed the lesser of 100% of compensation or $46,000 per year. An employee's elective contributions to the plan are limited to $15,500 on a calendar year basis (as adjusted for inflation annually). The maximum Catch-Up contribution that an employee may make is $5,000.00. Amounts must not violate special non-discrimination rules.
	3. INVESTMENT OF PLAN ASSETS. Plan assets can be invested in equity products, like mutual funds, stocks, debt-free real estate or debt instruments, like T-bills, CDs, or insurance products such as life insurance and annuity policies.
	4. PARTIES WHICH ARE FAVORED. Since funds are typically employee dollars, the higher paid, younger employee is favored because he or she has longer time for funds to accumulate tax-deferred.
	5. MATCHING CONTRIBUTIONS. Some employers choose to match each dollar put in by the employee with some multiple; e.g., 50%, 75%, etc. If the employee does not contribute, neither does the employer.
	6. QUALIFIED NON-ELECTIVE CONTRIBUTIONS. If the "non-highly compensated" employees have not deferred enough, relative to what the "highly compensated" employees would like to defer, the Treasury Regulations permit the employer to make a contribution which is sufficient to bring the non-highly compensated employees up to the level necessary to support the highly compensated employee's deferral percentage. This type of contribution must always be fully vested. HIGHLY COMPENSATED EMPLOYEES INCLUDE: 5% owners (including ownership attribution) and employees earning more than $105,000 in the prior year. (Subject to cost of living increases).
	7. SALARY REDUCTIONS. Participants must sign a salary reduction agreement permitting a payroll deduction.
	8. WITHDRAWAL OF FUNDS. As with other Profit Sharing plans, the funds can generally be withdrawn without a penalty in the event of (a) Termination of employment after age 55 (with restrictions), (b) Death or Disability or (c) Attainment of age 59 1/2, if the plan terms permit. However, under a Sec. 401(k) Plan, elective contributions can be withdrawn if the participant has a "financial hardship." Under the Treasury Regulations, this is defined as "immediate and heavy financial need where funds are not reasonably available from other sources." There are "safe harbor" rules which spell out the conditions and requirements for "hardship distributions."
	9. TOP HEAVY PLANS. In order to meet top heavy minimum allocation requirements, employee contributions are not recognized. Therefore, in a top heavy plan, the employer will be required to contribute up to 3% of compensation if any key participant contributes up to 3% of his or her compensation. Matching contributions made by the employer count towards the minimum top heavy contribution.
	10. DISCRETIONARY PROFIT SHARING CONTRIBUTIONS. In addition to any matching and/or top heavy contributions, an employer may make discretionary profit sharing contributions from year to year so long as the allocation among the participants is on a nondiscriminatory basis. These contributions can be made to the plan up to the due date plus any extension granted to the employer to file its tax return. Any employer contributions made on a discretionary basis, that are not required to maintain the plan qualification, may have gradual vesting.

NON-DISCRIMINATION RULES

A mathematical test is used to determine whether a plan is discriminatory unless the plan is a Simple 401(k) or Safe-Harbor 401(k) Plan. First, all employees eligible to participate are divided into two groups according to their compensation and other criteria.

The highly compensated may defer up to two times what the non-highly compensated did in the current or prior year (depending upon the document provisions), for the first 2%. If the non-highly compensated on average deferred between 2% and 8%, the highly compensated may contribute an additional 2%. (If more than 8%, then up to 125% of the rate).

The amounts contributed by the non-highly compensated employees will set the limit on how much the highly compensated can defer.

IF THE NON-HIGHLY COMPENSATED EMPLOYEES DEFERRED - (on average)

THEN THE HIGHLY COMPENSATED EMPLOYEES CAN DEFER - (on average)

In the first year of a plan, Highly Compensated Employees can defer up to 5% of their compensation (on average).

EXAMPLE: Assume that the plan permits employee contributions of up to 15% of salary and bonus.

Average Percentages: Highly Compensated = 6.67%
Non-highly Compensated Employees = 5% ---- The Test is satisfied.
*Maximum contribution is limited to $15,500 per participant (as adjusted for inflation annually).

SIMPLE AND SAFE HARBOR PLANS

A Simple 401(k) Plan is exempt from the discrimination tests and top-heavy rules if it provides an employer contribution of either:

This employer contribution must always be 100% vested. No other additional employer contributions are permitted, and the employer cannot have any other qualified plans. Only employers with 100 or fewer employees can have a Simple 401(k) plan. The maximum deferral is reduced from $15,500 to $10,500.

Another type of 401(k) plan is called a Safe Harbor 401(k) Plan, and is also exempt from the discrimination test but not the top-heavy rules. It allows deferrals up to $15,500 and also allows an employer to make additional contributions beyond those that are required.

The required employer contribution is either:

The required employer contribution must be 100% vested at all times, but any additional employer contributions can be subject to a vesting schedule.

ROTH 401(k)

This is a new feature starting in 2006 where some or all of the employee elective contributions could be after tax contributions.  An existing plan must be amended to allow for Roth 401(k) contributions.  Contact us for additional details.

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