Return To 401(k) & Annuities

Cash or Deferred-Sec. 401 (k) Plan

The Basics: Any profit sharing or stock bonus plan which meets certain participation requirements of IRC Sec. 401(k) can be a cash or deferred plan. An employee can agree to a salary reduction or to defer a bonus which he or she has coming. Tax exempt entities may also adopt a 401(k) plan.

How It Works
  1. Employee has the option of taking cash or having it paid to tie trust for retirement. This is equivalent to an employee tax deductible contribution. However, employee deferrals are subject to PICA.
  2. Any additional employer contributions are tax deductible. IRC Sec. 404(a)
  3. Employer contributions, if any, are not taxed currently to the employee. IRC Secs. 402(a) and 403(a)
  4. Earnings accumulate income tax-deferred. TRC Sec. 501(a)
  5. Distributions can be tax-favored (eligible for 5-year forward averaging or rolled over into an IRA) at retirement. IRC Secs. 402 and 403

Two Types Of Plans

1. Salary Reduction: An employee can agree to a salary reduction; e.g., 10% of compensation which the employer then pays to the retirement plan trust. It is deductible to the employer but is not included in the employee's gross income. (This is clearly the most common type of plan.) However, employee deferrals are subject to FICA and FUTA. The employer must deposit employee deferrals no later than 15 business days after the close of the month during which deferrals were made.

2. Cash or Deferred: The employer can decide to pay a bonus and give the employees the following choices:

  • 1. Take it as cash.

  • 2. Defer it to the trust.

  • 3. Take part and defer the rest.

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    How Much Will There Be At Retirement?

    This will depend upon three factors:

    1. The frequency and amount of contributions.

    2. The number of years until retirement, and

    3. The investment return.

    The risk or poor investment returns rests upon the employee. However, if the investment results are favorable, the participant will have a larger fund at retirement age.

    Additional Considerations

    A. Maximum Annual Allocation: Employers may deduct contributions of up to of covered payroll. This amount includes participant deferrals, employer matching contributions and employer discretionary contributions.

    B. Individual Limits: The allocation total of employer contributions arid employee deferrals to a participant's account may not exceed the lesser of 25% of compensation or $30,000 per year. An employee's elective contributions to the plan are limited to $10,000 on a calendar year basis (as adjusted for inflation in 1999). Amounts deferred must not violate special non-discrimination rules.

    C. Investment of Plan Assets: Plan investments must be diversified and prudent. Subject plan provisions, plan assets can be invested in equity products like mutual funds, stocks and debt free real estate, or in debt instruments like T-Bills and CD’s, insurance products such as life insurance and annuity policies may also be used For plan years beginning after 12/31/99, if the plan mandates that employee deferrals must be invested in employer stock, or the trustee can direct such an investment, then the maximum that can be invested in employer stock is 1%.

    D. Parties which are Favored: Since funds are typically employee dollars, the higher paid younger employee is favored because be or she has a longer time for fluids to accumulate tax-deferred.

    E. Matching Programs: Some employers choose to match each dollar put in by the employee with some multiple; e.g., 50%, 75%, etc. If the employee does not contribute neither does the employer.

    F. Qualification Contributions: If the non-highly compensated employees have not deferred enough, relative to what the "highly compensated" employees would like to defer, the Treasury Regulations permit the employer to make a contribution which is sufficient to bring the non-highly compensated employees up to the level necessary to support the highly compensated employee's deferral percentage. This type of contribution must always be fully vested. Highly compensated employees include 5% or more owners and those earning more than $80,000 in the prior year. If the employer so chooses, the employer may include only those earning more than $80,000 who are also among the top-paid 20% of employees.

    G. Salary Reductions: Participants must sign a salary reduction agreement permitting a payroll deduction.

    H. Withdrawal of Funds: As with other profit sharing plans, the funds can generally be withdrawn in the event of (a) termination of employment, (b) death or disability, (c) attainment of age 59 1/2. However, under a Sec. 401(k) plan, elective contributions can be withdrawn if the participant has a "financial hardship." Under the Treasury Regulations, this is defined as "immediate and heavy financial need where funds are not reasonably available from other sources." There are "safe harbor" rules which spell out the conditions and requirements for "hardship distributions"

    I. Forfeitures: As participants leave the company and separate from the plan, those less than 100% vested in the employer contribution account forfeit that part of the account in which they are not vested. The non-vested forfeitures may then be allocated to the remaining participants. Those participants who remain in the plan the longest will share in the most forfeitures.