Your qualified plan can include a cash or deferred arrangement under which participants can choose to have you contribute part of their before-tax compensation to the plan rather than receive the compensation in cash. A plan with this type of arrangement is popularly known as a "401(k) plan." (As a self-employed individual participating in the plan, you can contribute part of your before-tax net earnings from the business.) This contribution is called an "elective deferral" because participants choose (elect) to defer receipt of the money.
In general, a qualified plan can include a cash or deferred arrangement only if the qualified plan is one of the following plans.
- A profit-sharing plan.
- A money purchase pension plan in existence on June 27, 1974, that included a salary reduction arrangement on that date.
For tax years beginning after December 31, 2005, a 401(k) plan may allow employees to contribute to a qualified Roth contribution program. For more details, see Qualified Roth Contribution Program,
A partnership can have a 401(k) plan.taxmap/pubs/p560-017.htm#en_us_publink10008992
The plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.taxmap/pubs/p560-017.htm#en_us_publink10008993
If your plan permits, you can make matching contributions for an employee who makes an elective deferral to your 401(k) plan. For example, the plan might provide that you will contribute 50 cents for each dollar your participating employees choose to defer under your 401(k) plan.taxmap/pubs/p560-017.htm#en_us_publink10008994
You can also make contributions (other than matching contributions) for your participating employees without giving them the choice to take cash instead. These are called nonelective contributions.taxmap/pubs/p560-017.htm#en_us_publink10008995
No more than $230,000 of the employee's compensation can be taken into account when figuring contributions other than elective deferrals in 2008. This limit increases to $245,000 in 2009.taxmap/pubs/p560-017.htm#en_us_publink10008996
If you had 100 or fewer employees who earned $5,000 or more in compensation during the preceding year, you may be able to set up a SIMPLE 401(k) plan. A SIMPLE 401(k) plan is not subject to the nondiscrimination and top-heavy plan requirements discussed earlier under Qualification Rules. For details about SIMPLE 401(k) plans, see SIMPLE 401(k) Plan in chapter 3.taxmap/pubs/p560-017.htm#en_us_publink1000135957
Certain rules apply to distributions from 401(k) plans. See Distributions From 401(k) Plans, later.taxmap/pubs/p560-017.htm#en_us_publink10008997
There is a limit on the amount an employee can defer each year under these plans. This limit applies without regard to community property laws. Your plan must provide that your employees cannot defer more than the limit that applies for a particular year. For 2008, the basic limit on elective deferrals is $15,500. This amount increases to $16,500 for 2009. This limit applies to all salary reduction contributions and elective deferrals. If, in conjunction with other plans, the deferral limit is exceeded, the difference is included in the employee's gross income. taxmap/pubs/p560-017.htm#en_us_publink10008998
A 401(k) plan can permit participants who are age 50 or over at the end of the calendar year to also make catch-up contributions. The catch-up contribution limit for 2008 is $5,000. This amount increases to $5,500 for 2009. Elective deferrals are not treated as catch-up contributions for 2008 until they exceed the $15,500 limit, the ADP test limit of section 401(k)(3), or the plan limit (if any). However, the catch-up contribution a participant can make for a year cannot exceed the lesser of the following amounts.
- The catch-up contribution limit.
- The excess of the participant's compensation over the elective deferrals that are not catch-up contributions.
Your contributions to your own 401(k) plan are generally deductible by you for the year they are contributed to the plan. Matching or nonelective contributions made to the plan are also deductible by you in the year of contribution. Your employees' elective deferrals other than designated Roth contributions are tax free until distributed from the plan. Elective deferrals are included in wages for social security, Medicare, and federal unemployment (FUTA) tax.taxmap/pubs/p560-017.htm#en_us_publink10009000
Employees have a nonforfeitable right at all times to their accrued benefit attributable to elective deferrals.taxmap/pubs/p560-017.htm#en_us_publink10009001
You must report the total amount of employee elective deferrals deferred in boxes 3, 5, and 12 of your employee's Form W-2. See the Instructions for Forms W-2 and W-3.taxmap/pubs/p560-017.htm#en_us_publink1000100239
Your 401(k) plan can have an automatic enrollment feature. Under this feature, you can automatically reduce an employee's pay by a fixed percentage and contribute that amount to the 401(k) plan on his or her behalf unless the employee affirmatively chooses not to have his or her pay reduced or chooses to have it reduced by a different percentage. These contributions are elective deferrals. An automatic enrollment feature will encourage employees' saving for retirement and will help your plan pass nondiscrimination testing (if applicable). For more information, see Publication 4674, Automatic Enrollment 401(k) Plans for Small Businesses.taxmap/pubs/p560-017.htm#en_us_publink1000100244
Under an eligible automatic contribution arrangement (EACA), a participant is treated as having elected to have the employer make contributions in an amount equal to a uniform percentage of compensation. This automatic election will remain in place until the participant specifically elects not to have such deferral percentage made (or elects a different percentage). There is no required deferral percentage.taxmap/pubs/p560-017.htm#en_us_publink1000100245
Under an EACA, you may allow participants to withdraw their automatic contributions to the plan if certain conditions are met.
- The participant must elect the withdrawal no later than 90 days after the date of the first elective contributions under the EACA.
- The participant must withdraw the entire amount of EACA default contributions, including any earnings thereon.
If the plan allows withdrawals under the EACA, the amount of the withdrawal other than the amount of any designated Roth contributions must be included in the employee's gross income for the tax year in which the distribution is made. The additional 10% tax on early distributions will not apply to the distribution.taxmap/pubs/p560-017.htm#en_us_publink1000100246
Under the terms of the EACA, employees must be given written notice of the terms of the EACA within a reasonable period of time before each plan year. The notice must be written in a manner calculated to be understood by the average employee and be sufficiently accurate and comprehensive in order to apprise the employee of their rights and obligations under the EACA. The notice must include an explanation of the employee's right to elect not to have elective contributions made on his or her behalf, or to elect a different percentage, and the employee must be given a reasonable period of time after receipt of the notice before the first elective contribution is made. The notice also must explain how contributions will be invested in the absence of an investment election by the employee.taxmap/pubs/p560-017.htm#en_us_publink1000121010
A qualified automatic contribution arrangement (QACA) is a new type of safe harbor plan. It contains an automatic enrollment feature and mandatory employer contributions are required. If your plan includes a QACA, it will not be subject to the ADP test (discussed later) nor the top-heavy requirements (discussed earlier). Additionally, your plan will not be subject to the ACP test if certain additional requirements are met. Under a QACA, each employee who is eligible to participate in the plan will be treated as having elected to make elective deferral contributions equal to a certain default percentage of compensation. In order to not have default elective deferrals made, an employee must make an affirmative election specifying a deferral percentage (including zero, if desired). If an employee does not make an affirmative election, the default deferral percentage must meet the following conditions.
- It must be applied uniformly.
- It must not exceed 10%.
- It must be at least 3% in the first plan year it applies to an employee and through the end of the following year.
- It must increase to at least 4% in the following plan year.
- It must increase to at least 5% in the following plan year.
- It must increase to at least 6% in subsequent plan years.
Under the terms of the QACA, you must make either matching or nonelective contributions according to the following terms.
- Matching contributions.You must make matching contributions on behalf of each non-highly compensated employee in the following amounts.
Other formulas may be used as long as they are at least as favorable to non-highly compensated employees. The rate of matching contributions for highly compensated employees, including yourself, must not exceed the rates for non-highly compensated employees.
- An amount equal to 100% of elective deferrals, up to 1% of compensation.
- An amount equal to 50% of elective deferrals, from 1% up to 6% of compensation.
- Nonelective contributions.You must make nonelective contributions on behalf of every non-highly compensated employee eligible to participate in the plan, regardless of whether they elected to participate, in an amount equal to at least 3% of their compensation.
All accrued benefits attributed to matching or nonelective contributions under the QACA must be 100% vested for all employees who complete two years of service. These contributions are subject to special withdrawal restrictions, discussed later.taxmap/pubs/p560-017.htm#en_us_publink1000121013
Each employee eligible to participate in the QACA must receive written notice of their rights and obligations under the QACA, within a reasonable period before each plan year. The notice must be written in a manner calculated to be understood by the average employee, and it must be accurate and comprehensive. The notice must explain their right to elect not to have elective contributions made on their behalf, or to have contributions made at a different percentage than the default percentage. Additionally, if the QACA contains two or more investment options, the notice must explain how contributions will be invested in the absence of any investment election by the employee. The employee must have a reasonable period of time after receiving the notice to make such contribution and investment elections prior to the first contributions under the QACA.taxmap/pubs/p560-017.htm#en_us_publink10009002
If the total of an employee's deferrals is more than the limit for 2008, the employee can have the difference (called an excess deferral) paid out of any of the plans that permit these distributions. He or she must notify the plan by April 15, 2009 (or an earlier date specified in the plan), of the amount to be paid from each plan. The plan must then pay the employee that amount by April 15, 2009.taxmap/pubs/p560-017.htm#en_us_publink10009003
If the employee takes out the excess deferral by April 15, 2009, it is not reported again by including it in the employee's gross income for 2009. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.
If the employee takes out part of the excess deferral and the income on it, the distribution is treated as made proportionately from the excess deferral and the income.
Even if the employee takes out the excess deferral by April 15, the amount will be considered for purposes of nondiscrimination testing requirements of the plan, unless the distributed amount is for a non-highly compensated employee who participates in only one employer's 401(k) plan or plans.taxmap/pubs/p560-017.htm#en_us_publink10009004
If the employee does not take out the excess deferral by April 15, 2009, the excess, though taxable in 2008, is not included in the employee's cost basis in figuring the taxable amount of any eventual benefits or distributions under the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.taxmap/pubs/p560-017.htm#en_us_publink10009005
Report corrective distributions of excess deferrals (including any earnings) on Form 1099-R. For specific information about reporting corrective distributions, see the Instructions for Forms 1099-R and 5498.taxmap/pubs/p560-017.htm#en_us_publink10009006
The law provides tests to detect discrimination in a plan. If tests, such as the actual deferral percentage test (ADP test) (see section 401(k)(3)) and the actual contribution percentage test (ACP test) (see section 401(m)(2)), show that contributions for highly compensated employees are more than the test limits for these contributions, the employer may have to pay a 10% excise tax. Report the tax on Form 5330. The ADP test does not apply to a safe harbor 401(k) plan (discussed below) nor to a QACA. Also, the ACP test does not apply to these plans if certain additional requirements are met.
The tax for the year is 10% of the excess contributions for the plan year ending in your tax year. Excess contributions are elective deferrals, employee contributions, or employer matching or nonelective contributions that are more than the amount permitted under the ADP test or the ACP test.
See Regulations sections 1.401(k)-2 and 1.401(m)-2 for further guidance relating to the nondiscrimination rules under sections 401(k) and 401(m).
If the plan fails the ADP or ACP testing, and the failure is not corrected by the end of the next plan year, the plan can be disqualified.
If you meet the requirements for a safe harbor 401(k) plan, you do not have to satisfy the ADP test, nor the ACP test, if certain additional requirements are met. For your plan to be a safe harbor plan, you must meet the following conditions.
- Matching or nonelective contributions. You must make matching or nonelective contributions according to one of the following formulas.
These mandatory matching and nonelective contributions must be immediately 100% vested and are subject to special withdrawal restrictions.
- Matching contributions. You must make matching contributions according to the following rules.
- You must contribute an amount equal to 100% of each non-highly compensated employee's elective deferrals, up to 3% of their compensation.
- You must contribute an amount equal to 50% of each non-highly compensated employee's elective deferrals, from 3% up to 5% of their compensation.
- The rate of matching contributions for highly compensated employees, including yourself, must not exceed the rates for non-highly compensated employees.
- Nonelective contributions. You must make nonelective contributions, without regard to whether the employee made elective deferrals, on behalf of all non-highly compensated employees eligible to participate in the plan, equal to at least 3% of the employee's compensation.
- Notice requirement. You must give each eligible employee written notice of their rights and obligations with regard to contributions under the plan, within a reasonable period before the plan year.
The other requirements for a 401(k) plan, including withdrawal and vesting rules, must also be met for your plan to qualify as a safe harbor 401(k) plan.