Defined Contribution Plans
Cash or Deferred Arrangements
In simple terms, the 401(k) Plan allows an employee to choose between receiving his full salary in cash or having a portion of it deferred to a tax sheltered, interest bearing retirement plan. The money contributed to the plan is not reported for income tax purposes.
This type plan is extremely attractive in light of the potential non-deductibility of some I.R.A. contributions. Even though many employees may not be able to make a tax-deductible contribution to an I.R.A., they may make the same type of contribution to the 401(k) Plan and receive the same tax benefits. Furthermore, they may contribute to a Roth account regardless of income.
All 401(k) plans must have a definitely determinable allocation method. That is, the method used to allocate contributions to the individual participants must be specified in the plan document. There are various methods available to allocate the contributions. The benefit provided at normal retirement age is an account balance. There is no guarantee of benefits at normal retirement.
Type of Plan
Technically, a 401(k) Plan is usually a form of a profit sharing plan, though it could be a stock bonus plan.
General Anti-Discrimination Test
A qualified plan must “benefit” at least 70% of all non-highly compensated employees. In the case of a 401(k) Plan, an employee who is eligible to make contributions will be treated as “benefiting” under the plan.
The special non-discrimination tests limit elective deferrals by highly compensated employees based on the relationship of the ” actual deferral percentage ” for the group of highly compensated employees to the “actual deferral percentage” for non-highly compensated employees.
The “actual deferral percentage” for a group of employees is the sum of the “deferral percentages” for the employees in the group, divided by the number of employees in the group.
The “deferral percentage” for an employee is the percentage of that employee’s compensation that has been electively deferred for the year. Eligible employees who makes no deferrals during the year have a zero deferral percentage. For employees who are a participant in two or more cash or deferred arrangements, the deferral percentage is the sum of elective deferrals made under all such arrangements, expressed as a percentage of the employee’s compensation. Any deferrals by highly compensated employees in excess of the averages will be returned to them.
Safe Harbor 401(k)
One of the newer versions of the 401(k) style plan is the Safe-Harbor plan. Under this plan an employer may exchange a guaranteed contribution in the form of a matching or profit sharing contribution and waived vesting in exchange for no testing.
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