A 401(k) plan is a type of profit sharing plan that includes an elective salary deferral provision. The employer typically has the ability to make a matching contribution that is tied to the elective salary deferral, as well as a profit sharing contribution that is allocated to all eligible participants. Plan participants usually have the ability to select their own individual asset allocations from various investment alternatives available to the plan.
Roth 401(k) Profit Sharing Plans
A Roth 401(k) plan is a new feature of a 401(k) plan that permits participants to make after-tax salary deferrals into a 401(k) plan. If the employer elects to offer the Roth 401(k) provision, participants will have a choice of making pretax or after-tax salary deferrals.
Eligibility
Employee eligibility requirements for 401(k) plans are typically one year of service and age 21.
Contributions
The three common 401(k) contribution types are:
- Elective salary deferral – the employee can defer up to $15,500 for 2008. (This is an indexed amount subject to cost of living adjustments and may change each year.)
- Employer matching – the employer can make a discretionary contribution based on a percentage of the employee’s elective salary deferrals.
- Profit sharing – can be allocated in any method available to regular profit sharing plans.
An employer’s maximum deduction is limited to 25% of the annual compensation paid to eligible employees.3 In addition, the employer must meet several nondiscrimination tests, which may further limit the amounts deferred by certain highly paid employees.
Employees age 50 and older may make a $5,000 catch-up contribution, which does not count against their individual maximum annual additions limit of the lesser of $46,000 or 100% of compensation.
Advantages
A 401(k) plan allows both employer and employees to contribute toward retirement while reducing the current tax burden of both. Because employees are actively involved as participants, 401(k) plans typically have a high visibility level in terms of the employee’s perception of the benefit being provided by the employer.
401(k) Safe-harbor Plans
A Safe Harbor 401(k) plan is not subject to nondiscrimination tests, therefore all employees have the opportunity to maximize deferrals.
Eligibility
Employee eligibility requirements are the same as those for a 401(k) profit sharing plan.
Contributions
Contribution types and limits are the same as those for a 401(k) profit sharing plan, with a ”safe harbor” exception. To qualify for the exception, the employer must make a 100% vested contribution of either:
- 3% of compensation for each eligible employee orA matching contribution of up to 4% of compensation.
- The safe harbor then permits the owner and other highly compensated employees to defer the maximum without regard to the deferral levels of the nonhighly compensated employees.
Advantages
In addition to the advantages offered by a 401(k) profit sharing plan, the Safe Harbor 401(k) avoids the nondiscrimination testing that may limit the amounts the highly compensated employees may defer.
Owner Only/One-person 401(k)
A recent tax law permits the owner/partner/shareholders of a small business, and their spouses, to maximize contributions if net compensation is less than $184,000 (indexed for 2008).
Eligibility
Employee eligibility requirements are typically limited to attainment of age 21.
Contributions
Contribution types and limits are the same as those for a 401(k) profit sharing plan, including Roth 401(k) salary deferrals.
Advantages
Filing a Form 5500EZ is not required until either the total plan assets exceed $250,000 (for plan years beginning in 2007 and later) or an employee other than an owner/partner/shareholder or their spouse enters the plan. Additionally, discrimination testing is not required until an employee other than an owner/partner/shareholder or their spouse enters the plan.
