OVERVIEW OF PLAN TYPES

An employer who decides to sponsor a retirement plan for its employees is faced with countless choices. Certain plans represent administrative ease. Other plans come with more favorable tax incentives. Still other plans provide flexibility. An employer can pick the funding arrangement, as to whether the employer or the employee or both will contribute to the retirement plan. Selecting the right plan is important, because it impacts the benefits received, the cost of operation, the employer's tax liability, perception by employees, and, ultimately, overall company profitability.

401(k) PLANS

A 401(k) plan, named after the Internal Revenue Code section, is not a type of plan at all, rather a type of funding arrangement (qualified cash or deferred arrangement) that is part of a profit sharing, stock bonus or pre-1974 money purchase pension plan. A 401(k) arrangement allows employees to defer a portion of their current compensation into a tax-qualified plan to accumulate tax-free, and to be taxed at a subsequent stage when the funds are distributed. These deferrals are non-forfeitable, i.e. 100% vested, and may be matched by the employer, but are not required to be.

ADVANTAGES

  • The employee is able to defer taxes on current compensation, and the income thereon accumulates tax-free
  • The employer gets a current deduction for all contributions made
  • A 401(k) plan provides higher contribution limits than an individual retirement account (IRA)
  • Wider popularity with the recent increased annual deferral limits, as well as the increased additional annual catch-up limits for employees age 50 and older
  • Employees have individual flexibility over determining the amount of pre-tax contributions to the plan
  • Deductible employer discretionary and/or matching contributions may also be made to the plan
  • Provides incentive for employees to save for their retirement
  • Certain taxpayers may receive a tax credit for some or all of their 401(k) contributions under the Retirement Savings Tax Credit
  • Tax-exempt organizations, churches, and Indian tribal governments may also adopt a 401(k) plan
  • 401(k) deferrals may be withdrawn for hardships or upon the attainment of age 59 1/2 if the plan document allows. In most cases, withdrawals prior to attaining age 59 1/2 will incur an excise tax
  • Most plans allow participant direction of investments. Whether this meets the criteria of an advantage in all cases, is a moot subject

POSSIBLE DISADVANTAGES

  • Exposure to a plethora of nondiscrimination tests, for instance, ADP/ACP tests, top-heavy tests, etc. This may limit the ability of highly-paid employees, and owners to participate in the plan
  • It may make employers lethargic to make corporate contributions, since the plan experiences a steady stream of employee contributions
  • Additional fiduciary and administrative burdens relating to participant investment choices
  • Elective deferrals directly eat into an employee’s available current compensation
  • Participants bear the risk of investment experience and investment choice
  • In-service distributions of elective deferrals are restricted
  • A 401(k) feature may not be provided under a current money purchase plan

ANALYSIS

One of the major frustrations experienced by plan sponsors relates to failed nondiscrimination tests, which limit the ability of highly paid employees and owners to participate in the plan. There are a few options available:

  1. In an automatic enrollment (or negative election) 401(k) plan, the employee is automatically enrolled in the 401(k) plan upon meetingthe plan’s eligibility requirements, unless the employee elects affirmatively not to participate. The employee MUST be given the option to elect out. Plans utilizing this method have seen increased rates of participation and contribution. The IRS has indicated that the default contribution rate can be higher than 3%, but studies suggest that the average default contribution rate in these plans is about 2%, and the most popular default rate is 3%.
  2. Employers may increase non-highly paid employee participation through education, and incentives such as matching contributions, more liberal vesting schedules, etc.
  3.  They may use the prior year testing method, and limit highly-paid employee contributions, based on the results of prior year tests, and thus avoid having to make refunds at the end of the year on account of failed tests.
  4. The employer may utilize the safe harbor option. Providing certain “safe harbor” contributions exempts the plan from ADP/ACP nondiscrimination testing. In most cases, this also eliminates top-heavy testing.

EXAMPLES

– (FOR ILLUSTRATION PURPOSES ONLY)
  1. The ADP Test verifies whether or not benefits derived by highly compensated employees unreasonably exceed those derived by non-highly compensated employees. The calculation of limits is shown below:
    NHCE Average Rates Maximum HCE Average Rates 2.00% or less NHCE Average Rate times 2 2.00% to 8.00% NHCE Average Rate plus 2.00% 8.00% or greater NHCE Average Rate times 1.25

    Comp. Deferral ADP Failed Deferral ADP Passed Deferral ADP Passed
    HCE1 $245,000 $16,500 6.73% $16,500 6.73% $11,025 4.50%
    HCE2 $100,000 $8,000 8.00% $8,000 8.00% $7,500 7.50%
    HCE Average Rates: 7.37% 7.37% 6.00%
    NHCE1 $20,000 $0 0.00% $500 2.50% $0 0.00%
    NHCE2 $30,000 $1,000 3.33% $1,500 5.00% $1,000 3.33%
    NHCE3 $40,000 $3,000 7.50% $4,000 10.00% $3,000 7.50%
    NHCE4 $50,000 $0 0.00% $0 0.00% $0 0.00%
    NHCE5 $60,000 $5,500 9.17% $6,000 10.00% $5,500 9.17%
    NHCE Average Rates: 4.00% 5.50% 4.00%
  2. The employer has the discretion to match employee deferral contributions. Below are examples of various formulas.
    In these examples, the employer matches a certain percentage on deferrals up to 5% of compensation:

    Comp. Deferral 75% Match 50% Match 25% Match
    HCE1 $245,000 $23,000 $9,188 $6,125 $3,063
    HCE2 $100,000 $8,000 $3,750 $2,500 $1,250
    Total $345,000 $31,000 $12,938 $8,625 $4,313
    NHCE1 $20,000 $0 $0 $0 $0
    NHCE2 $30,000 $1,000 $750 $500 $250
    NHCE3 $40,000 $4,000 $1,500 $1,000 $500
    NHCE4 $50,000 $0 $0 $0 $0
    NHCE5 $60,000 $6,000 $2,250 $1,500 $750
    Total $200,000 $11,000 $4,500 $3,000 $1,500
    Grand Total $545,000 $42,000 $17,438 $11,625 $5,813

CONCLUSION

The introduction of pension law changes through EGTRRA in 2001 makes 401(k) plans even more attractive. Contributions of employee elective deferrals no longer reduce the employer’s deduction limits. These modifications allow employers additional creative options.

Firstly, the sponsor of a defined benefit pension plan can now adopt a deferral-only 401(k) plan, and deduct contributions to both plans. Employees can receive enhanced benefits under this arrangement. Secondly, this allows self-employed individuals with no employees to deduct a much higher percentage of their net earned income than previously. By way of example, a sole proprietor with $160,000 in net earned income can contribute $10,000 (more if catch-up eligible) as 401(k) deferrals, and $30,000 as profit sharing contributions, reducing the individual’s compensation to roughly $122,500, after calculating self-employment taxes.

The flexibility in contributions and withdrawals continues to make 401(k) plans the number one choice in employer-sponsored retirement plans. Assets in 401(k) plans have increased on average 13 percent per year, from $385 billion in 1990 to an estimated $1.9 trillion at year-end 2003 (Sources: Investment Company Institute, U.S. Department of Labor, and Federal Reserve Board). 401(k) plans now cover an estimated 42 million American workers, and are an extremely valuable means for the employer and employee to cooperate in saving for the employee’s retirement.