EMPLOYEE 401K PLANS
DESIGN OF 401(k) RETIREMENT PLANS
The 401(k) type of retirement plan is perhaps the fastest growing plan in the country. This is true because employers find it a cost-efficient and attractive addition to their benefit package and because assets grow rapidly when employers and employees are both contributing. The demand for administrative, communication, investment and insurance services have increased for these plans.
401(k) is the section of the Internal Revenue Code that allows pre-tax contributions to a qualified profit sharing or stock bonus plan. This type of plan is also known as a Cash or Deferred Arrangement (CODA). The most common CODA is a salary reduction arrangement where each plan participant agrees in writing with the employer to defer a percentage of his or her salary into the plan. Some plans also permit payment of bonuses to be treated as a CODA. Employees may play a very active role in a 401(k) plan and that may explain why they are so popular. Employees can choose:
- Whether or not to participate
- How much they will defer
- Where their contributions will be invested
Many companies and institutions have at least considered establishing a 401(k) plan, and are most likely to fit at least some of these descriptions:
- More than 30 employees
- Employing “white collar” or professional employees
- Where the general employee group expresses an interest
- With current profit sharing plans
- Those expressing dissatisfaction with current plans
- Those desiring greater investment control
Companies whose objectives are primarily tax advantages are not usually good prospects, and nonprofit or governmental organizations generally do not establish a 401(k) plan.
A 401(k) plan is one of the least expensive benefits an employer can offer. Health and life insurance benefits are usually much more costly. Employers’ costs are predictable - expenses are a known factor and employer contributions can be determined each year. In fact, an employer may decide not to contribute in any year.
A 401(k) plan can be a major factor in reducing turnover, motivating employees and recruiting new, qualified employees. Most companies either currently maintain or are considering a 401(k) plan. Employers and employees who can no longer make deductible IRA contributions find 401(k) an excellent alternative.
The benefits of a 401(k) plan should be available to all levels of employees who meet specific eligibility requirements. The typical maximum eligibility requirements in a 401(k) plan are one year of service and age 21. However, these requirements can be lower. An employee completes one year of service when he or she works at least 1,000 hours in a twelve-month period. The service requirement eliminates most part-time employees. Employees covered under a collective bargaining agreement can also be excluded.
ELIGIBILITY DESIGN ISSUES
Setting the eligibility requirements at age 21 and one year of service means that employees must be eligible to participate in the Plan on the next entry date after they meet the eligibility requirements - January 1 or July 1 for a calendar year plan. This is called a dual entry date. Eligibility of age 20 ½ and 6 months of service permits a single entry date, usually January 1 for a calendar year plan.
More frequent entry dates can be used, but will increase employer costs. The Plan can allow all current employees to be immediately eligible while imposing different age and service requirements on new employees. Eligibility requirements allow an employer to leave out younger, short-service employees, which in turn will help control costs. By not including short-service employees, who are least likely to participate, it is easier to meet special discrimination tests.
Four different types of contributions can be made to a 401(k) plan, and most plans permit several types:
- EMPLOYEE ELECTIVE DEFERRALS
Eligible employees sign an agreement with the employer to defer a percentage of their salary or forego a bonus into the plan. An employee is permitted to revise the election - generally at the end of a payroll period or quarter. These contributions are made to the plan on a pre-tax basis although Social Security tax (FICA) must still be paid. The maximum amount a participant may contribute on this basis in 2007 is $15,500, which will increase in increments of $500 based on inflation.
A plan participant who reached 50 years of age before the end of the taxable year is eligible for “catch up” contributions (deferrals) of $2,500 for Simple 401(k) plans and $5,000 for other 401(k) plans.
- EMPLOYER MATCHING CONTRIBUTIONS
The employer contributes a percentage of each employee’s elective deferrals. This is a great way to motivate employees to participate in the plan.
- EMPLOYER NON-MATCHING CONTRIBUTIONS
The employer contributes on behalf of all the eligible employees regardless of whether or not they made employee elective deferrals. This is identical to a profit-sharing contribution and can be made in combination with a Matching Contribution. The maximum the employer can contribute is the lesser of $45,000, or 100% of compensation (catch up contributions not included).
- ROLLOVER ACCOUNTS
A rollover is a transfer from another qualified plan. If an employee wishes to roll over funds from another plan, these are placed in the employee’s personal account on a non-forfeitable basis. There is little reason to exclude this feature.
CONTRIBUTION DESIGN ISSUES
The Employer Matching contributions may be made only on employee deferrals up to a specified percentage. To help control and limit the employer’s expense, a match on the first 6% of employee deferral is common.
These contributions may be left flexible and not specified at a particular percentage in the plan. They can also be tied to the prior year’s profits. It is felt this matching provision can help motivate employees to achieve higher profits in future years in order to receive a high match.
Declaring the match for the coming year, just prior to when the employees enroll is a good way to encourage participation. Even if it is not used initially, it may be desirable in the future.
EMPLOYER NON-MATCHING CONTRIBUTIONS
Employers who want to maximize a deduction for the company frequently make these contributions at the end of the year. They can then contribute the difference remaining between the maximum allowable deduction of 15% of the total compensation for all of the eligible employees and what has already been contributed, in a year of significant profits.
This is another way to maximize the dollars that are being saved for the highly compensated employees whose employee deferrals may have been limited because of the special discrimination test or because they reached the maximum dollar limit. Even if it is not used initially, it may be desirable to do so in a big profit year.
This provision is recommended when the 401(k) Plan is replacing a prior terminated plan. It may also be used by employees who wish to transfer their balances from a prior employer’s plan. Including this provision is of value to new employees and will maximize the benefits of the Plan.
Employer and employee contributions to a 401(k) plan can accumulate a comfortable retirement for employees. Pre-tax employee contributions, deductible employer contributions (deductible to the employer and not currently taxed to employees) and tax-deferred growth of the contributions through investment combine to offer one of the most logical ways to save for retirement. The total of all contributions can be projected for the plan year by reviewing the employee enrollment forms. This projection may allow a company to take advantage of reduced expense charges.
All contributions made by the employee, whether deductible, non-deductible or rollover, are 100% vested. An employee’s right to his or her total account balance in the plan may be subject to a vesting schedule. The vested percentage is based on the number of years of service the employee has worked for the company. Employee Elective Deferrals are always 100% vested. A vesting schedule may be imposed on Employer Matching Contributions and Employer Non-Matching Contributions.
The following vesting schedules are most common:
- 3 year cliff vesting - employees are 0% vested for the first two years of service and 100% after three.
- 2/6 year vesting - employees are 0% vested for the first year of service, 20% after two and an additional 20% each year thereafter, with 100% after six.
COMMON VESTING SCHEDULES
Years of Service3-Year Cliff6-Year Graded
A vesting schedule is frequently applied to Employer Non-Matching contributions because employers use this feature to both attract and retain employees.
Many employers find a vesting schedule appealing because it represents a “hook” to retain employees. The non-vested amount the employee leaves behind when he or she terminates employment is forfeiture. Using forfeitures to reduce the employer’s future contributions may help to make the plan as cost-efficient as possible.
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.
SPECIAL DISCRIMINATION TESTS
Special tests apply to a 401(k) plan, which are designed to ensure that the plan benefits the non-highly compensated employees as well as the highly compensated employees. The tests are calculated by averaging the percentages of Employee Elective Deferrals for these two groups, the highly compensated and the non-highly compensated, and comparing the two Average Deferral Percentages (ADP). There are two tests and a plan must pass one:
1. The ADP for the highly compensated cannot be more than 125% of the ADP for the non-highly compensated.
2. The ADP for the highly compensated cannot be more than 200% of the ADP for the non-highly compensated, but the difference between the ADP’s cannot be more than two percentage points.
Employees who are eligible, but who choose not to contribute any employee elective deferrals are counted in the average as a zero. Designing the plan to use the maximum allowable eligibility may help to exclude those employees who are least likely to contribute - this can avoid lowering the average with zeros. The key to a successful 401(k) plan is to motivate as many of the non-highly compensated employees as possible to participate so that the ADP will be higher. Employer Matching Contributions are a great motivator to encourage non-highly compensated employees to participate.
Because employees who participate in a 401(k) plan are contributing their own monies, they are concerned about having access to their account balances. This type of retirement plan is primarily designed to provide benefits at retirement. However, there are a number of ways to take a withdrawal before that time.
Any distribution before age 59 ½ or early retirement age will incur a 10% premature withdrawal penalty as well as ordinary income tax. However, this 10% is not usually a penalty tax factor since a time of hardship is usually a time of reduced income, already placing the employee in a lower tax bracket. Hardship withdrawals are strictly defined and incur a 10% premature withdrawal penalty plus ordinary income taxes if taken before age 59 ½.
- Termination of employment
- Age 59 ½ (in some plans)
- Hardship withdrawals
Loans have become a more popular way to allow employees limited access to their account. Loans have a wide appeal, but should not be promoted as a selling feature because they are an administrative burden, additional fees are charged and a loan may undermine the primary objective of the plan - retirement savings.
When withdrawals occur, an employee can take a distribution in-kind instead of cash. The in-kind withdrawal can be rolled over into an IRA or registered in the individual’s personal account.
- Conduct a preliminary meeting with the employer’s decision-makers. The issues expressed in this memorandum should be discussed.
- Prepare a census of employees, including dates of birth, dates of service, current compensation and percentage of ownership.
- Discuss employer goals and attitudes toward contributions.
- The financial advisor should prepare a formal written proposal detailing all services, fees, design checklist and product information.
- The employer agrees to install a 401(k) plan and determines contributions.
- The employer’s attorney prepares a plan document, or reviews a prototype for correct completion.
- The financial advisor provides all supporting forms, employee payroll stuffers, and a poster announcing the plan to the employees.
- Employee meetings are held to discuss the plan and the investment choices. A slide presentation might be appropriate. Employees receive a Plan highlight brochure, fund prospectuses, a Summary Plan Description, a personal illustration and an enrollment form. These are generally distributed at a group meeting, followed by brief personal enrollment and explanation sessions.
- Enrollment forms are collected and the financial advisor sets up the plan on the record keeping system.
- The financial advisor provides a manual of instructions and forms to be used in the ongoing maintenance of the plan for the payroll or human resources department.
- The first contributions are invested and the employees receive investment confirmations.
A prototype plan is one that has been filed and approved with the IRS, and employers may use it by checking off the applicable provisions they desire. Plan documents, support services and products are available from investment organizations.
Sources: Financial Planning Consultants, Inc.
Tax Facts 2007, National Underwriter Company
Employer Fiduciary Responsibilities