A 401(k) is a feature of a qualified profit sharing company retirement plan that allows employees to contribute a portion of their wages to a retirement account on their behalf. The contributions may be pre-tax or post tax. When pre-tax they are called 401(k) contributions or traditional 401(k) contributions. When post-tax they are called Roth 401(k) contributions.
Within a 401(k) plan, employers can contribute matching or profit sharing contributions to employees’ accounts. Distributions, including earnings, are includible in taxable income (except for qualified distributions of designated Roth accounts).
Solo 401(k) Plan - A 401(k) plan can be established for a single person company or for a company with many employees. When a company contains only one employee, the plan is commonly called a Solo 401(k) plan.
A 401(k) plan enables employees to save for retirement without paying income tax on those monies if elected. The annual contribution limits under this qualified retirement plan are higher than under an Individual Retirement Account (IRA) that the employee could fund on his own. See below in the numerical example.
A Solo 401(k) plan has the same benefits and features as a 401(k) plan for several employees, but since it is only for the owner-employee, it does not have discrimination testing or filing requirements until plan assets reach a threshold dollar amount. It also enables the owner to save a greater dollar amount than is available in an IRA.
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Whether you are setting up a 401(k) plan for your company or a plan has been in place for several years, Administrative Retirement Services, Inc. (ARS) strongly recommends that you take the time to read and understand some basic plan information.
This is a brief overview of some very detailed concepts which should help avoid future problems because the reader will have a basic understanding of what is required to have a qualified 401(k) plan.
Maintaining a qualified status means the plan is drafted according to IRS rules, and that all necessary tests are performed and passed annually. If the tests do not pass, corrective action such as refunds processed or contributions made are taken to have these tests deemed passed.
Written Plan Document
In order to have a qualified 401(k) plan, the Internal Revenue Code requires that a plan sponsor have a written plan and trust. The plan document lists all of the plan provisions and must remain current with the law changes.
Most companies choose to use a prototype plan document because it provides all the necessary plan options, is inexpensive and is pre-approved by the IRS. In addition, it is easier to read than an individually drafted document and probably better written, since the document drafter normally practices solely in the ERISA area.
ARS sponsors plan documents, which means we have prototype plan documents that were approved by the IRS. Document sponsorship demonstrates our commitment to qualified plans.
Summary Plan Description
Plan sponsors must provide all plan participants and beneficiaries a Summary Plan Description which summarizes plan provisions in layman’s terms. The Employee Retirement Income Security Act (ERISA) requires a number of additional disclosures of plan and benefit information to participants and beneficiaries, such as an annual participant statement and an annual Summary Annual Report (SAR).
Nondiscrimination Testing (ADP/ACP)
The employee pre-tax deferrals to a qualified 401(k) plan are not currently taxed if a retirement plan satisfies a nondiscrimination test. This test compares employee deferrals of highly compensated employees (HCE) to those of non-highly compensated employees (NHCE).
An employee is considered an HCE in 2016 if in 2015 they earned $120,000 or more, or if they own more than five percent of the business in the current or preceding year. Ownership is also attributable to spouses and lineal ascendants and descendants (i.e., parents and children) of each owner. Employers can limit the HCEs to the top 20 percent of employees meeting the plan eligibility requirements and earning $120,000 or more in 2015.
The nondiscrimination test which applies to employee deferrals is the Actual Deferral Percentage (ADP) test, and for the employer matching contributions is the Actual Contribution Percentage (ACP) test.
The ADP test is satisfied if the ADP of HCEs satisfies either a 1.25 test or a 2% spread test. The 1.25 test is satisfied if the ADP of the HCE group does not exceed 1.25 times the ADP of the NHC group. The 2% spread test is satisfied if the ADP of the HCE group is not more than two percentage points greater than the ADP of the NHC group, and the ADP of the HCE group is not more than twice the ADP of the NHC group. The ACP test must also pass by similar rules.
Plan sponsors can elect to use the prior year’s NHCE ADP in performing the current year’s nondiscrimination test. This alleviates unwanted refunds to HCEs by providing an exact percent HCEs may contribute for the current year.
The process of performing the ADP and ACP tests are as follows:
• Determine the HCEs and NHCEs.
• Calculate an ADP or ACP ratio for each eligible employee by dividing their applicable contributions by their compensation. Eligible participants not contributing to the plan have a ratio of zero.
• Calculate the averages for the HCEs and NHCEs by totaling the contribution percentages for all eligible participants in each group, and dividing this by the number of employees in each group.
• Compare the averages for the HCEs and NHCEs.
Another important test for a 401(k) plan is the top-heavy test.
Under IRC 416, if the key employee(s) adjusted account balances are greater than 60 percent of adjusted plan assets at the beginning of the plan year, the plan is considered top-heavy. The account balances are adjusted by subtracting the account balances of participants terminated in prior plan years, subtracting rollover balances, adding distributions to participants employed in the previous year and adding in-service distributions made during the last five years.
In order for the key employees to make elective deferrals to a top-heavy 401(k) plan, a top-heavy minimum contribution equal to the largest deferral percentage made by a key employee, up to 3 percent, must be contributed by the employer.
Definition of a Key Employee:
• An officer having annual compensation in excess of 50 percent of the annual dollar limitation for defined benefit plans in effect for such plan year ($170,000 for 2015 testing).
• A more than five percent owner.
• A more than one percent owner whose annual compensation exceeds $150,000.
Ownership is also attributable to spouses and lineal ascendants and descendants (i.e., parents and children).
To avoid nondiscrimination and top-heavy testing, a plan sponsor can elect 30 days prior to the beginning of the plan year or initial plan set-up to utilize Safe Harbor provisions, which are described more here.
A plan is not qualified unless it benefits a certain percentage of employees. Internal Revenue Code section 410(b) requires that all plans pass either a ratio percentage test (RPT) or average benefits test (ABT). A RPT must be performed for each contribution type within a plan (employee deferrals, profit sharing, matching).
To perform a RPT, the number of NHCEs benefitting in the plan contribution is divided by the number of NHCEs eligible for the plan contribution. Then the number of HCEs benefitting in the plan contribution are divided by the number of HCEs eligible for the plan contribution. The NHCE ratio must be at least 70% of the HCE ratio to pass the RPT. If the RPT fails, the plan can be tested to see if it passes an ABT.
Under the ABT, the plan may benefit employer-defined classes of employees which are reasonable, and do not discriminate in favor of HCEs. The classifications must be found to be nondiscriminatory based on either a safe harbor rule or a facts and circumstances test.
The ABT compares the ratio percentage calculated in the RPT to the safe harbor percentages and to the unsafe harbor percentages. The test automatically passes if the ratio percentage is equal to or greater than the safe harbor percentage.
Match contributions allow the plan sponsor to allocate employer contributions only to participants who make an employee deferral contribution. Matching formulas can be stated in the plan or can be discretionary each year. We recommend making the match discretionary so that it can be changed each year based on business conditions. The match is usually a percentage of each employee’s deferral contribution. The employee deferrals which are matched may be limited to a percentage of the participants’ compensation.
Profit Sharing Contribution
Profit Sharing contributions can be allocated proportionate to salary, integrated with social security (participants who earn more than the social security wage base can receive an extra contribution based on the wages above the base), cross-tested, or assigned a certain dollar amount per hour of service or a flat dollar amount per participant.
Profit sharing and match contributions may be calculated and deposited each payroll period or at the end of the year.
Plan sponsors can allocate this contribution to all participants or can limit it to all participants employed at the end of the year who have completed 1,000 hours of service during the year, subject to the coverage testing rules. If employer contributions are limited to participants employed at the end of the year, the contributions should not be made until the end of the year. Click these links for more information on Profit Sharing Plans, Cross-Tested Plans.
Contribution Deposit Rules
In order for employer contributions to qualified plans to be deductible, they must be deposited by the employer’s federal tax return due date, according to Internal Revenue Code section 404(a)(6).
If the tax return is extended, the taxpayer is given additional time to deposit the employer’s contribution. This rule applies to both cash and accrual basis taxpayers.
Employer contributions include profit sharing, money purchase, defined benefit and matching contributions.
A calendar year C or S corporation sponsors a 401(k) profit sharing plan, which offers both profit sharing and matching contributions. The 2014 corporate tax return (1120 or 1120S) is due by March 16, 2015. Profit sharing and matching contributions must be deposited by March 16, 2015 in order to be deductible, regardless of whether the taxpayer is under the cash or accrual basis of accounting.
If the corporate tax return is extended before March 16, 2015 using form 7004, the corporation has until September 15, 2015 to deposit the 2014 profit sharing and matching contributions. These dates would also apply for defined benefit and money purchase contributions.
Sole proprietors are unincorporated businesses. They are normally calendar year taxpayers and file form 1040 and report their business activity on schedule C.
Calendar year 2014 1040s are due by April 15, 2015. For Employer contributions to be deductible, they must be deposited by April 15, 2015. The sole proprietor’s tax return can be extended for six months to October 15, 2015 by completing form 2668. If the return is extended, the date by which the employer’s contribution must be deposited is also extended.
Note that even if both extensions are filed and granted, money purchase and defined benefit contributions for 2014 must be deposited by September 15, 2015 due to minimum funding requirements. Employer contributions are considered deposited timely if they are mailed by the due date of the taxpayers tax return.
401(k) Contributions / Elective Deferrals
401(k) contributions (also called elective deferrals) which an employer withholds from employees’ pay, must be deposited into the employees’ accounts in the plan as soon as administratively feasible, or within 7 business days for plans with under 100 participants. Plans with 100 or greater participants are expected to have a faster process. Any 401(k) contributions deposited after this deadline are considered late. If there are late contributions, the employer is required to make up any lost earnings to the participants, and the IRS charges the company a 15% penalty on the lost earnings amount.
Filing & Bonding Requirements
Form 5500 Filing Requirements
All qualified plans are required to file Form 5500, which is due seven months after the plan year end and can be extended 2 ½ months. Calendar year plan Form 5500s are due July 31 and can be extended until October 15 using Form 5558. Failure to file a timely Form 5500 can result in a $25 per day penalty up to $15,000.
One-participant plans do not have to file Form 5500EZ until they have more than $100,000 in plan assets. However, by filing the form, the statute of limitations begins and runs three years from the date of filing. Thus, filing tax forms is always prudent.
Distributions & 1099-R Reporting
Distributions normally take place upon attainment of a distributable event, such as retirement, severance from employment or death. Terminated participants can rollover their funds into another plan or IRA or take a lump sum distribution. Form 1099-R must be distributed to participants who have received a retirement plan distribution by January 31 of the year following the year in which the distribution took place. Form 1099-R reports the taxable status of a distribution. If funds are rolled over from one plan to another plan or to an IRA, the funds are not taxable, but do require the filing of a Form 1099-R.
Form 1099-Rs may be created by the employer, the TPA, or the investment firm. It is the responsibility of the employer to ensure that participants receive the Form 1099-R by the January 31 deadline. Failure to file a timely Form 1099-R may result in penalties ranging from $15 - $50 per day, up to $100,000.
Fidelity Bonding Requirements
According to Section 412 of ERISA, all Trustees (Fiduciaries) of Corporate Retirement and Welfare Funds must obtain a Fidelity Bond. The amount of the bond required is 10% of the Plan assets, with a maximum bond of $500,000. If your company already carries Fidelity Bond coverage, you can contact the person who wrote this coverage and have them add the retirement plan as an additional named insured. If your company does not have a Fidelity Bond at present, you should obtain a Commercial Blanket Fidelity Bond for your retirement plan.
Employee Deferral Contribution Limit
For 2015, plan participants can contribute 100% of wages or self-employment income up to $18,000. This is known as the 402(g) limit. If the participant will attain the age of 50 during the plan year, they can contribute an additional $6,000 for 2015 called a catch-up contribution. Click here for a complete list of all the annual dollar limits.
Employer Contribution Limit
Employers may contribute profit sharing or matching contributions up to 25% of eligible compensation for the entire company. For 2015, eligible compensation includes W-2 wages or income subject to self-employment taxes up to $265,000. For 2015, the wage limit is $265,000. The contributions can be discretionary or have a set formula, and must be deposited by the taxpayer’s tax return due date with extension.
Annual Additions Limit
A qualified plan must limit the annual additions, or total benefits, that are allocated to a participant's account each year. Defined contribution annual additions are limited to the lesser of 100% of the participant's section 415 compensation or $53,000 in 2015. Defined benefit annual additions are limited to $210,000 in 2015.
Plan Design Ideas
Cross-testing is a specific way to allocate a profit sharing contribution. This method allows a plan sponsor to define classes of employees and allocate a profit sharing contribution differently among the classes, subject to an average benefits test. Click here for more information about cross-testing.
Safe Harbor 401(k) Plan
Safe Harbor plans automatically pass nondiscrimination and top-heavy testing. A Safe Harbor 401(k) Plan requires that the plan sponsor make a contribution to receive the benefit of automatically passing testing. Click here for more information about safe harbor plans.
Cash Balance Plan
Cash Balance plans are a form of defined benefit plans that allow employers the option to significantly increase their employer contributions to plans. In most situations business owners that are older than their employees are able to receive between $75,000 - $200,000 in employer contributions by contributing between 8% - 12% of the employees compensation to their employees. Click here for more information about cash balance plans.
The above rules and tests provide many planning opportunities. For assistance in understanding or implementing any of these concepts, contact Administrative Retirement Services, Inc.
Set Up This Plan
To setup this plan for your organization, please complete our Online Questionnaire.
You may also complete the questionnaire offline by downloading the form here and then faxing the completed form to our office.