| Characteristics of a 401(k) Plan | |||||||||||||||||||||
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| Explanation | |||||||||||||||||||||
| Section 401(k) of the Internal Revenue Service code permits an
employer to set up a qualified plan under which employees can contribute a portion of
their pre-tax pay on a tax-deferred basis. In addition to the tax deferral on the employee's contribution, earnings on the contribution are also tax-deferred. Both contributions and earnings may be eligible for favorable 5-year forward averaging tax treatment upon distribution (other than a pre-termination hardship withdrawal of funds). A 401(k) Plan is generally qualified as a Profit Sharing Plan, but the employer need not contribute to the plan; it may be completely funded through employee pay deferrals. 401(k) Plan monies can be invested in the same manner and are subject to the same regulations as other qualified plans. |
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| Plan Provisions | |||||||||||||||||||||
| An employer has some flexibility in determining plan provisions such as eligibility for participation, retirement age, methods of distribution, etc., as they do in other types of qualified plans. However, the amount of pay higher-paid employees can defer may be limited by a special discrimination test that applies to 401(k) Plans only. | |||||||||||||||||||||
| The Discrimination Test | |||||||||||||||||||||
This test says that the "highly-compensated"
employees (as defined by the IRS) cannot shelter significantly more earnings than the
lower-paid or "non-highly-compensated" employees. There are two phases to
the test, which is relatively complex. A summary of the two phases of the test
follows:
The maximum percentage that can be deferred is 15% of pay (excluding employer contributions and forfeitures, if any). The maximum dollar amount of salary deferral in the year 2000 is $10,500. The maximum dollar deferral limit is indexed based on a formula developed by Congress. The current indexing formula will have the effect of limiting the level of increases from year to year. In certain years, there may not be an increase at all. For the year 2000, the eligible compensation that can be used is $170,000. It should be stressed that the percentage test is based on eligible employees, not only on employees who elect to participate. Therefore, communication of the plan to the employees becomes extremely important -- the more employees who join the plan, the greater the amount that higher-paid employees can defer. |
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| Fail-Safe Method | |||||||||||||||||||||
| The plan must be monitored annually to determine that the percentages are not discriminatory. A "fail-safe" method to insure a minimum level of contributions from lower-paid employees is to make participation in the plan mandatory. | |||||||||||||||||||||
| Employer Contributions | |||||||||||||||||||||
| Many employers match employee's tax deferred contributions
at a ratio of anywhere from $.25 to $1.00 for every dollar contributed. Some
employers begin the plan with a $.25 match and then increase their contributions in future
years as financial conditions warrant. Other employer contribution formulas are also
possible, including a discretionary profit sharing contribution at year end. Employer matching contributions are counted toward the discrimination test immediately only if they are 100% vested in the employee. If the employer does not wish to vest the contributions immediately, any of the vesting schedules for a typical defined contribution plan may be incorporated into the plan. The most common is a six-year graded schedule. |
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| Investments | |||||||||||||||||||||
| 401(k) Plan monies are invested in the same manner as
other defined contribution plans. The employer has a wide range of investment
vehicles from which to choose, including pooled equity and bond funds, mortgage funds,
money market funds, limited partnerships, etc. The employer may choose to direct
investments or delegate this function to an investment manager/advisor.
It is common in 401(k) Plans for employers to set up several investment funds and permit the employees to choose the fund or funds in which his or her plan monies are invested. |
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| Plan Distributions | |||||||||||||||||||||
| A participant's plan account is available at termination,
death, disability, age 59 ½, or retirement. The favorable 5-year forward averaging
is available in all these occurrences if the employee has participated in the plan for at
least 5 years. Funds from an employee's account may also be available for certain types of financial hardship while they are still employed. However, in-service withdrawals are subject to ordinary income tax and a 10% penalty tax in the year in which received. |
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Alpha & Omega, Inc. Financial Management
Consultants |
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