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401(k)

Piggybank on wooden table with stacks of coins beside it. A hand putting a coin into the piggy bank with"401k" written in chalk beside it.

401(k) plan is a qualified employer-established plan to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax-deferred basis.

Employee 401(k) contribution are automatically deducted from their paycheck each pay period. This money is taken out before the employees paycheck is taxed. The contributions are invested at the employees direction into one or more funds provided in the plan. Employers often “match” employee contributions, but are not required to do so. While the investments grow in the employees 401(k) account, they do not pay any taxes on it.

There are several types of 401(k) plans available to employers – traditional 401(k) planssafe harbor 401(k) plans and SIMPLE 401(k) plans. A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both.

safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals.

The SIMPLE 401(k) plan was created so that small businesses could have an effective, cost-efficient way to offer retirement benefits to their employees. This plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans. As with a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.

401(k) plans offer many benefits, but there are restrictions also.

  • The company sets the eligibility requirements, within certain guidelines, at the time the plan is established.
  • Employer can restrict individuals with less than one year service, union members, non US citizens, part-time workers, etc., from being eligible for the plan.
  • Contributions to plan can come from voluntary employee salary reduction, from employer, or both.
  • Employees are immediately 100% vested with their own salary reduction tax deferred contributions.
  • Employee withdrawals before age 59 1/2 may be subject to 10% penalty.
  • Employees who retire any time during the calendar year in which they turn 55, or later, are not subject to the 10% penalty.
  • Employers can establish a vesting schedule, within certain guidelines, for the contribution the company makes to the 401(k).
  • Employers are not required nor obligated to make any contribution to the 401(k), although employer may have some obligation to contribute if plan is deemed top heavy.
  • Turnkey and Internet based plans are available.
  • Excellent range of investment options available for the plan sponsor to offer within the plan.
  • The investment choices in most plans range from 8 to 25 options. The average plan has about 19.
  • 401(k) plans may permit “self-directed investment accounts” and company stock purchase within the plan.
  • Employee contributions to the plan are not subject to federal income taxes until a distribution from the plan is made. Any investment gains and earnings also enjoy tax deferral until distribution.
  • This type of plan can permit loans and hardship withdrawals, but is not required to do so.
  • Participants can start, stop contribution during course of year, as determined by the company.
  • The employer can receive certain tax benefits for contributions.
  • Plans are subject to top heavy and discrimination testing.
  • Typically the amount the owners and highly compensated individuals can contribute to a 401(k) is a function of the contributions of the other employers.
  • 401(k) plans can be subject to IRS Form 5500 filings.
  • Generally, the vendor selected by the plan sponsor does all accounting, participant reporting, testing, and files 5500 reports with the IRS.

401(k) plans are subject to numerous and complex rules, regulations and tax qualification requirements. Be sure to consult with a qualified professional before making any decisions.

About the author

Thomas Elliott

Education: Brooklyn Law School, Brooklyn, New York. Pace University, White Plains, New York.
Professional Associations and Memberships: American Bar Association, New York State Bar, The Association of the Bar of the City of New York, Brooklyn Bar Association, National Academy of Elder Law Attorneys (NAELA).

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