401(k) plans can be a powerful tool to promote financial security in retirement. They provide a host of benefits for employers, including aiding in hiring and retention, tax-advantaged contributions and the ability to include all employees, owners and managers. Employees also enjoy advantages such as flexibility with contributions and investment options, tax-free contributions and earnings, and often portability if they leave the company.
Establishing a 401(k) Plan
You must decide whether to set up the plan yourself or to consult a professional to help establish and maintain the plan. You also need to decide which type of 401(k) plan is best for you.
- Traditional 401(k) plans offer the most flexibility. Employers have discretion over whether to make contributions on behalf of all participants, to match employees’ deferrals, or to do both. Annual testing ensures that benefits for rank-and-file employees are proportional to benefits for owners/managers.
- Safe harbor 401(k) plans include several kinds of 401(k) plans that aren’t subject to the annual benefits testing required with traditional 401(k) plans. However, employees in these plans must receive a certain level of employer contributions.
- Automatic enrollment 401(k) plans allow you to automatically enroll employees and place deductions from their salaries in certain default investments, unless the employee elects otherwise. This is an effective way for employers to increase participation in their 401(k) plans.
In addition, there are four initial steps to establishing your 401(k) plan.
- Adopt a written plan document. This serves as the foundation for day-to-day plan operations and you are bound by the terms of this document. If you have hired someone to help with your plan, that person likely will provide the document, or you may want to obtain assistance from a financial institution or professional. You have flexibility in choosing some plan features, while others are required by law.
- Arrange a trust fund for the plan’s assets. A plan’s assets must be held in trust to assure that assets are used solely to benefit the participants and their beneficiaries. The trust must have at least one trustee to handle contributions, plan investments and distributions. If you set up your plan through insurance contracts, the contracts do not need to be held in trust.
- Develop a recordkeeping system. An accurate recordkeeping system will track and properly attribute contributions, earnings and losses, plan investments, expenses and benefit distributions, and will help prepare the plan’s annual return/report that must be filed with the government. If a financial institution assists in managing the plan, it typically will help keep the required records.
- Provide plan information to employees eligible to participate. You must notify employees who are eligible to participate in the plan about certain benefits, rights and features. You also may want to provide employees with information on the advantages of your 401(k) plan to encourage participation.
Operating a 401(k) Plan
Once you have established a 401(k) plan, you assume certain responsibilities – or you may choose to hire a professional to help in the operation of the plan. These are the main responsibilities associated with a 401(k) plan.
- Participation – Typically, a plan includes a mix of rank-and-file employees and owners/managers. However, some employees may be excluded from a 401(k) plan if they are under 21, have not completed a year of service or are covered under a collective bargaining agreement that does not provide for participation in the plan.
- Contributions – In all 401(k) plans, participants can make contributions through salary deductions. Employers can also make contributions for participants.
401(k) Plan Types
Traditional 401(k) Plan
If you decide to contribute to your plan, you have options. You can contribute a percentage of each employee’s compensation to the employee’s account (a non-elective contribution), you can match the amount your employees decide to contribute, or you can do both. Under a traditional 401(k) plan, you also have the flexibility of changing the amount of employer contributions each year, according to business conditions.
Safe Harbor 401(k) Plan
Under a safe harbor plan, you can match each eligible employee’s contribution, dollar for dollar, up to 3 percent of the employee’s compensation, and 50 cents on the dollar for employee contributions that exceeds 3 percent, up to 5 percent of each employee’s compensation. Alternatively, you can make a non-elective contribution equal to 3 percent of compensation to each eligible employee’s account. Each year you must make either matching or non-elective contributions.
Information On Contributions
401(k) plans may permit employees to make after-tax contributions through salary deduction. These designated Roth contributions, as well as gains and losses, are accounted for separately from pretax contributions. However, they are treated the same as pretax contributions for many key aspects of the plan, such as contribution limits. As a result of a recent law change, employers may amend their 401(k) plans to allow participants to transfer certain amounts in the plan to their designated Roth account in the plan.
Employer and employee contributions and forfeitures (non-vested employer contributions of terminated participants) are subject to a per-employee overall annual limitation. This limit is the lesser of:
- 100 percent of the employee’s compensation, or
- $51,000 for 2013
In addition, the amount employees can contribute under any 401(k) plan is limited to $17,500 for 2013.
All 401(k) plans can allow catch-up contributions of $5,500 for 2013 for employees age 50 and over.