These plans - 401(k) plans - are a popular type of defined-contribution plan and million of workers are covered by them.
There are several tax advantages to a 401(k). By contributing a portion of his/her salary to a 401(k) the employee reduces the income on which he/she will currently be taxed. In addition, the employer may be able to make a contribution to the plan which will be deductible to the employer but not taxable currently to the employee. Amounts going into the 401(k) accumulate tax free until, perhaps many years later, they are withdrawn from the plan. The accumulation in the plan will, of course, eventually be taxable when the employee takes it out of the plan.
The principal disadvantage of 401(k) plans - other than the eventual taxability of the withdrawals fromthe 401(k) - is the extreme costs of administration. It costs money to set up the plan and to administer the plans on a day to day basis. Extensive government reports are required and the employees must be educated about the workings of the plan and must be informed about what is happening to their accounts. Because of the complexity and administrative cost of administering these plans, only moderate size to big employers should consider these plans. If there are only 20 employees in your company, consider a SIMPLE instead. If you have 100 or more employees, a 401(k) may be worth considering particularly if you are a CPA firm or law firm or pension benefit firm and have some familiarity with the complexity of the Form 5500 and the requirements of ERISA. For a very large company, say 5,000 employees, the 401(k) may be good for the employees and good for the employer and it will usually be less expensive and less time consuming to administer than a defined benefit plan.
Amounts going into a 401(k) come typically from two sources:
Employee contributions. The employee takes a "salary reduction" so that his/her contribution to the plan - while building up or accumulating for his/her benefit - is not considered taxable income in the current year. Let's say Mary's base salary is $30,000 a year and she elects to contribute 15 percent of it to the 401(k). Automatic salary reductions would typically be taken from her pay month by month and she would contribute $4,500 (or 15 percent of $30,000) to her 401(k) account. She'd pay social security tax and medicare tax but she wouldn't pay income tax on the full $30,000 of pay. For Federal tax purposes (and for most state income tax purposes as well) her taxable income would be only $25,500; that's her salary of $30,000 reduced by her contribution of $4,500 to the 401(k). These contributions are said to be "salary reductions" or "before tax" contributions. The plans are sometimes referred to as "cash or deferred arrangement" plans or "CODA" plans.
This deferral of income for tax purposes is limited to $15,000 for 2006 and will rise in subsequent years. The $15,000 limitation applies to all CODAs collectively in which a particular employee participates. Jane is eligible for CODA treatment with two employers: one her principal employer which pays her $85,000 a year; and another part-time employer from whom she earns $9,000 per year. The total amount she can exclude from income in 2006 is $15,000, not $24,000.
Participants in more than one CODA should be careful not to let the total CODA deferral exceed the current limit. The excess of the deferral over the current limit is taxed to the participant in the current year, that is, the year in which the money goes into the plan. Furthermore, the excess, even though taxed to the participant when it goes into the plan, is not treated as a part of the participant's investment in the plan so that when the excess is withdrawn at a later date it will be taxed to the recipient a second time. In 2006, Jane - see above - had $15,000 go into the plan of her full-time employer and another $6,000 into the plan of her part-time employer. She will be taxed on $6,000 of the $21,000 total contributed to the plans. If she wishes to avoid paying tax on this $6,000 a second time, she may withdraw it - and any income it has earned - by April 15 of the following year.
Employer contributions. These plans tend to be popular with employers as well. They encourage the employee to take at least partial responsibility for accumulating funds for her own retirement and they also permit the employer to make contributions to the employees account which are deductible to the employer without being current taxable to the employee. Many of these employer contributions are known as employer "matching contributions" because they will often match anywhere from 25 percent to 100 percent of the amount the employee contributes to the plan.
Suppose Mary (see above) who made an "elective contribution" of $4,500 to her account, worked for an employer who matched 50 percent of employee contributions. The employer would put a further $2,250 (50 percent of $4,500) into her account, a contribution that would be deductible to the employer but not taxable to Mary until years later when she withdrew money from the account.
Employers may instead make "discretionary profit-sharing contributions" to these accounts. Thus an employer might make a contribution of 5 percent of its profit with the contribution being divided among the various accounts on some allocation formula which might consider factors such as salary and age and years of service. If the employer makes these "discretionary profit-sharing contributions," the employer cannot make the contribution to a particular account contingent on the employee deferring a portion of her salary. Suppose Mary's employer wanted to make such a discretionary contribution. The contribution to Mary's account would be the same as that to Sam, another employee with the same employment characteristics as Mary except that Sam makes no pre-tax contribution to the account.
(A)Profit-sharing plans. It has been suggested that "profit sharing" is a misnomer for these plans partly because these plans are sometimes used by not-for-profit institutions and partly because for profit-oriented enterprises the employer's contribution need not be any particular percentage of profits. Nevertheless, in most such plans the employer's contribution is usually based on profits although the total contribution may be a different percentage of profit in year 2 than it was in year 1 and sometimes employers make a contribution even though they had an unprofitable year. The CCH U.S.Master Tax Guide and other sources have suggested that a better term might be a "discretionary contribution plan." In any case, employer contributions, if any, should be substantial and recurring and there must be a definite written formula used for allocating the emmployer's contributions amount the individual accounts maintained for the participants.
Amounts going into 401(k) plans (named after a section in the Internal Revenue Code) come from one of two sources: from voluntary "salary reductions" made by the participating employees or by contributions from the employer. To the extent the employee takes a "salary reduction" the amoount going into the plan is not included in the employee's income in that year. Similarly, the employer's contributions to the plan permit the employee to take the contribution in cash or as an "elective contribution" to the plan. The amount going into the plan as an "elective contribution" is not part of the employee's income for that year.
(B)Stock-bonus plans. Stock-bonus plans, like profit-sharing plans, are defined contribution plans and both types of plans have many of the same benefits and many of the same rules and limitations. To the extent these plans lead to emmployee ownership of the stock of the corporation they may confer benefits to the employer in addition to those available for profit-sharing plans. These "employee stock ownership plans" or ESOPs are not covered further here.
QUALIFICATION REQUIREMENTS. To qualify as a 401(k) plan, then plan must the following requirements among others:
NONDISCRIMINATION REQUIREMENTS. In addition to the limitations discussed above, plans cannot discriminate in favor of "highly compensated employees." Who is a highly compensated employee? Anybody who owns five percent or more of the employer during the plan year is a highly compensated employee. Jodi, who owns 70 percent of the outstanding stock of the corporation and has a salary of $250,000, is classified as a highly compensated employee. So is Harry who owns the remaining 30 percent of the stock even though his salary of $55,000 per year is modest.
The category of "highly compensated emmployees" also includes any employee who had compensation in the previous year in excess of $95,000 (this is the 2005 number and is indexed for inflation) and, if the employer so elects for the purpose of nondiscrimination tests, was among the top 20 percent of employees for compensation in the preceding year. In addition to Jodi and Harry, the company has 18 other employees none of whom, except for Jane, earned more than $50,000 in the prior year. Jane earned $105,000. The employer could elect to include Jane in the category of "highly compensated employees" for the purpose of the nondiscrimination tests.
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