401(k) plans are qualified defined contribution retirement plans. They are qualified because they meet the tax law requirements for favorable tax treatment and defined contribution in that the benefit at retirement will not be defined until all contributions are made. At retirement age, the individual will receive an income based upon the amount of money accumulated. Defined contribution plans, such as profit sharing plans, permit a maximum of $45,000 (2007) to be contributed in an employee’s name. However, the special option under which the 401(k) plans are instituted, limits an individual’s contribution to $15,500 in 2007. Special catch-up contributions, by participants age 50 or over, may be made.
Normally these plans have three accounts:
Employee tax-deferred (deductible) contributions
Employer matching contributions
Employer profit-sharing contributions
Tax Code Section 401(k) allows employees to set aside pre-tax income in a qualified savings plan and to accumulate interest on a tax deferred basis until withdrawal. The 401(k) plan is an option added to a qualified profit sharing plan, but it is more often referred to as a salary reduction plan. It allows employees to elect how much of their salary/bonus on a pre-tax basis is to be deposited to the plan. For tax purposes, this money is treated as a form of company contribution to a thrift plan. This tax treatment allows the employee’s taxable income to be reduced, therefore decreasing federal income and state income taxes. It does not, however, reduce FICA or Social Security.
Another unique benefit of the 401(k) plan is the contribution flexibility. Within certain limits, participants may choose how much income they will defer without regard to how much other participants contribute. This flexibility makes it possible for individuals with diverse savings objectives to attain their respective financial goals without interfering with the desires of colleagues.
401(k) plan advantages are:
401(k) contribution limits are now independent of 457 deferred compensation plans
Before January 2002, the deferral limits for 401(k) plans had to be coordinated with benefits under an IRC Section 457 deferred compensation plan, generally resulting in the then lower 457 limits. These limits are not now required to be coordinated.
Administrative costs are generally borne by the employer
These are not substantial, but when securities are purchased for the employee’s account, there is normally a substantial reduction in the standard expense charges.
Saving through payroll deduction is “painless”
401(k) contributions can be withheld on a payroll deduction basis. In addition, employees are more likely to save more since they contribute with each paycheck.
Some withdrawals are not subject to the 10% tax penalty
Withdrawals from a 401(k) plan due to separation of service or because of “financial hardship” are not subject to the ten-percent penalty tax. Financial hardship means an unanticipated “immediate and heavy financial need”. A distribution will be deemed to be made on account of: (1) “medical expenses” incurred by the employee, his spouse or dependents; (2) the purchase (excluding mortgage payments) of the employee’s principal residence; (3) payment of tuition, related educational fees, and room and board expenses for the next 12 months of post-secondary education for the employee, his spouse, children or dependents; or (4) the need to prevent eviction of the employee from his principal residence or foreclosure on the mortgage on his principal residence.
A participant may borrow from his or her account balance
Loans up to $50,000 if less than one half of the account may be made, subject to systematic repayment within five years except for loans made for a principal residence. Interest on loans is not deductible, except for loans secured by residence.
Roth 401(k) Plans are now allowed
Roth plans, while not deductible from current income, afford the advantages of tax free growth and no required distribution. A Roth 401(k) feature combines certain advantages of the Roth IRA with the convenience of 401(k) plan elective deferral-style contributions. The Roth 401(k) provisions were implemented by EGTRRA 2001 for plan years beginning on or after January 1, 2006, and were made permanent by the Pension Protection Act of 2006.
The IRS has issued a sample Roth amendment that may be adopted or tailored to the needs of 401(k) plan sponsors offering a Roth 401(k) feature. The amendment provides pre-approved plan language and an adoption agreement for adding the Roth feature to existing 401(k) plans.
BASIC PRINCIPLES
There are several guidelines, or restrictions, set forth by the IRS for 401(k) plans. The first restriction is the overall and individual contribution limits mentioned above. In order to ensure that a 401(k) plan is not established or operating in a discriminatory manner, the IRS has published non-discrimination tests. Companies offering 401(k) plans must pass these tests. The tests relate to:
The length of service required before participation
Participation requirements
Level of benefits for highly compensated individuals (compared to all other participants)
Non-discrimination against or in favor of any employee class
The 401(k) plan offers one of the best “tax shelters” available today with flexible options for both the employer and the employees.
Source: Tax Facts 2007, National Underwriter Company
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