401k & Profit Sharing Plans


What Is a 401(k)?
A 401(k) plan is an employer-sponsored qualified retirement plan allowing employees to defer a portion of their compensation. Employee deferrals are often supplemented by employer contributions.

A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts.

  • Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals).
  • Employers can contribute to employees’ accounts.
  • Distributions, including earnings, are includible in taxable income at retirement (except for qualified distributions of designated Roth accounts).


Types available
There are several types of 401(k) plans available to employers - traditional 401(k) plans, safe harbor 401(k) plans and SIMPLE 401(k) plans. Different rules apply to each. For tax-favored status, a plan must be operated in accordance with the applicable rules. Therefore, it is important that the employer be familiar with the special rules that apply to its plan so the plan is administered in accordance with those rules. To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan’s provisions. The following is a brief overview of important qualification rules. It is not intended to be all-inclusive.

Traditional 401(k) plans
A traditional 401(k) plan allows eligible employees (i.e., employees eligible to participate in the plan) to make pre-tax elective deferrals through payroll deductions. In addition, in a traditional 401(k) plan, employers have the option of making contributions on behalf of all participants, making matching contributions based on employees’ elective deferrals, or both. These employer contributions can be subject to a vesting schedule which provides that an employee’s right to employer contributions becomes nonforfeitable only after a period of time, or be immediately vested. Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.

Safe harbor 401(k) plans
A safe harbor 401(k) plan is similar to a traditional 401(k) plan, but, among other things, it must provide for employer contributions that are fully vested when made. These contributions may be employer matching contributions, limited to employees who defer, or employer contributions made on behalf of all eligible employees, regardless of whether they make elective deferrals. The safe harbor 401(k) plan is not subject to the complex annual nondiscrimination tests that apply to traditional 401(k) plans.

Safe harbor 401(k) plans that do not provide any additional contributions in a year are exempted from the top-heavy rules of section 416 of the Internal Revenue Code.

Employers sponsoring safe harbor 401(k) plans must satisfy certain notice requirements. The notice requirements are satisfied if each eligible employee for the plan year is given written notice of the employee's rights and obligations under the plan and the notice satisfies the content and timing requirements.

In order to satisfy the content requirement, the notice must describe the safe harbor method in use, how eligible employees make elections, any other plans involved, etc. Income Tax Regulations section 1.401(k)-3(d)(2) (PDF), contains information on satisfying the content requirement using electronic media and referencing the plan's Summary Plan Description.

The timing requirement requires that the employer must provide notice within a reasonable period before each plan year. This requirement is deemed to be satisfied if the notice is provided to each eligible employee at least 30 days and not more than 90 days before the beginning of each plan year. There are special rules for employees who become eligible after the 90th day. See Income Tax Regulations section 1.401(k)-3(d)(3) (PDF).

Both the traditional and safe harbor plans are for employers of any size and can be combined with other retirement plans.

SIMPLE 401(k) plans
The SIMPLE 401(k) plan was created so that small businesses could have an effective, cost-efficient way to offer retirement benefits to their employees. A SIMPLE 401(k) plan is not subject to the annual nondiscrimination tests that apply to traditional 401(k) plans. As with a safe harbor 401(k) plan, the employer is required to make employer contributions that are fully vested. This type of 401(k) plan is available to employers with 100 or fewer employees who received at least $5,000 in compensation from the employer for the preceding calendar year. Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.

Tax advantages
Two of the tax advantages of sponsoring a 401(k) plan are:

  • Employer contributions are deductible on the employer’s federal income tax return to the extent that the contributions do not exceed the limitations described in section 404 of the Internal Revenue Code. Refer to Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans), for more information about deduction limitations.
  • Elective deferrals and investment gains are not currently taxed and enjoy tax deferral until distribution.

Elective deferrals are not included in an employee’s gross income, which means that contributions are made with pre-tax dollars. Also, earnings inside a 401(k) plan accumulate on a tax-deferred basis.

The employer also gets a tax deduction, within certain limits, for contributions to the plan.

Employee withdrawals at retirement that exceed any nondeductible contributions made during the accumulation period (Roth contributions, for example) are generally taxed to the employee as ordinary income.

How Are 401(k) Contributions Determined?
There are annual limits on how much an employee can defer. For employees under age 50, deferrals can’t be more than $22,500 in 2023. When the plan allows, additional “catch-up” contributions permit participants age 50 and over to defer up to $30,000 (as indexed annually for inflation).

These limits apply to the sum of all of the employee’s deferrals to similar employer-sponsored defined contribution arrangements. In other words, 401(k) deferrals may be reduced if the employee also participates in other arrangements such as another employer’s 401(k) plan, 403(b) tax-deferred annuity or 457(b) plan.

Since many employers match all or a portion of each employee’s contribution (or simply make additional contributions), the total amount actually deposited into the employee’s account can exceed the individual limit. Overall “annual additions” to an employee’s 401(k) plan accounts from all sources—employee deferrals, employer matching contributions, possible employer profit-sharing contributions, etc.— cannot exceed the IRS Section 415 limit for defined contribution plans, which is the lesser of 100% of compensation or $66,000 in 2023 ($73,500 if age 50 or older).

What About Distributions?
As noted, withdrawals from a 401(k) account generally are taxed as ordinary income unless they represent a return of after-tax contributions. Also, if a participant takes a withdrawal prior to age 591⁄2, the participant will pay a 10% penalty tax on the taxable amount unless certain exceptions apply.

Required minimum distributions (RMDs) generally must begin no later than April 1 of the year following the year when the participant reaches age 73, beginning January 1, 2023. If the plan allows, participants who own 5% or less of the employing company may defer RMDs until actual retirement, if it occurs later than age 73. 

This information is not intended as authoritative guidance or tax or legal advice. You should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.

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How We Work

The Concept

  • A 401(k) plan is an employer-sponsored, qualified retirement account that an employee funds by deferring a portion of compensation.
  • Employee contributions to 401(k) plans are often supplemented by matching or discretionary employer contributions.

The Attraction

  • The employee does not pay current federal income tax on salary deferred into a 401(k) plan up to certain limits (although the deferred amount is still subject to Social Security and Medicare withholding taxes).
  • The exception is a contribution designated as a Roth deferral (if allowed by the 401(k) plan). An employee’s contributions to a Roth 401(k) are subject to current taxation, but the earnings on those after-tax contributions will later be distributed tax free, assuming certain criteria are met.
  • The employer receives a tax deduction, within prescribed limits, for any contributions made to the plan.
  • Earnings accumulate in a 401(k) plan on a tax-deferred basis.

Contributions

  • There are annual limits on elective employee deferrals to a 401(k) plan, with additional “catch-up” contributions permitted for participants age 50 and over. Within these limits, employees may elect the amount of salary they want to defer. Catch-up contributions are not available unless they are specifically allowed under the terms of the plan.
  • The annual limit for participants under age 50 is $23,000 in 2024. For participants age 50 and over, the limit is $30,500. These limits are adjusted annually for inflation.
  • Limits may be reduced if the employee participates in other deferral arrangements, such as a 401(k) sponsored by another employer, a 403(b) tax-deferred annuity or a 457(b) plan.
  • Since many employers match all or a portion of an employee’s deferral (or simply make additional contributions), the total amount actually contributed on behalf of an employee can exceed these limits. But the total amount from all sources cannot exceed the Section 415 limit for defined contribution arrangements—the lesser of 100% of compensation or $69,000 in 2024 ($76,500 if age 50 or older).

Other Requirements

  • A 401(k) plan must meet the nondiscrimination requirements that apply to all qualified plans, along with other unique 401(k) requirements.
  • Employees’ elective deferrals must be fully vested at all times.
  • There can be no discrimination between highly compensated employees (HCEs) and non- highly compensated employees (non-HCEs). Deferrals by HCEs are limited by the average deferrals of non-HCEs.
  • Employer matching contribution rules must apply uniformly to all employees.
  • Employee distributions must be based on certain specified events such as death, disability or retirement—not on completion of a certain period of participation or a certain number of years of service.

Withdrawals

  • While a 10% penalty tax generally applies to withdrawals taken before age 591⁄2, employees may avoid this penalty under certain conditions, including:
    • The employee leaves the employer after age 55, dies or becomes totally disabled.
    • The employee receives distributions as a series of substantially equal periodic payments for life (or life expectancy).
    • The employee receives the distribution for medical care, within certain limitations.
    • The employee takes the distribution upon the birth or adoption of a child.
    • The distribution is payable to an alternate payee under a “qualified domestic relations order” as defined by the IRS or by state law.
    • The distribution is to correct an earlier excess contribution or excess elective deferral.
    • Withdrawals are generally taxed as ordinary income, except to the extent they represent a return of the employee’s after-tax contributions. Roth deferrals may be withdrawn tax free when certain requirements are met.
  • Required minimum distributions (RMDs) must generally begin no later than April 1 of the year following the year the employee reaches age 73. However, employees may defer RMDs until actual retirement if it occurs after age 73, unless they own more than 5% of the company. The plan terms must provide for the exception.
  • Participants who fail to comply with the RMD rules face a 25% penalty tax on the amount that should have been distributed but was not. The penalty drops to 10% if the distribution error is corrected quickly.

The Bottom Line
401(k) plans offer an efficient, tax-advantaged way to prepare for retirement, often with a boost from employer contributions. The key to maximizing potential 401(k) retirement income is to start early, take full advantage of any matching or discretionary employer contributions, and defer as much out of current earnings as the contribution limits allow.

For Further reading, visit: https://www.irs.gov/retirement-plans/401k-plans

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What Are Profit-Sharing Arrangements?

A profit-sharing plan accepts discretionary employer contributions. There is no set amount that the law requires you to contribute. If you can afford to make some amount of contributions to the plan for a particular year, you can do so. Other years, you do not need to make contributions. Also, your business does not need profits to make contributions to a profit-sharing plan.

Profit-sharing plans are a specific form of qualified retirement plan called a “defined contribution plan” in which the employer makes periodic contributions to the plan. Each employee’s retirement benefit depends on the amount of the employer’s contributions plus the investment performance of each employee’s account.

While the employer is obligated to make the specified contributions, the employee bears the risk of investment performance. These plans may be set up so employees can invest and manage their individual accounts.

How Do Profit-Sharing Plans Work?

A distinguishing feature of profit-sharing plans is that employer contributions are not required every year. However, contributions must be “recurring and substantial.” Contributions in at least three out of every five years usually satisfy this requirement.

The employer has flexibility in determining how and when to make contributions. For example, the amounts can be based on company profits in excess of a certain amount, a percentage of the company’s net income, or an annual determination by the board of directors. While contributions are deductible, they are limited to 25% of the participating employees’ total compensation.

How Are Contributions Determined?

Employer contributions are often based on the employee’s total compensation, which can include salary, commissions, bonuses, overtime pay, etc. The maximum compensation that can be taken into account is $345,000 in 2024. The participant’s annual contribution is limited to the lesser of 100% of the employer’s includable compensation or $69,000 (in 2024).

If you do make contributions, you will need to have a set formula for determining how the contributions are divided. This money goes into a separate account for each employee.

One common method for determining each participant's allocation in a profit-sharing plan is the "comp-to-comp" method. Under this method, the employer calculates the sum of all of its employees' compensation (the total "comp"). To determine each employee's allocation of the employer's contribution, you divide the employee's compensation (employee "comp") by the total comp. You then multiply each employee's fraction by the amount of the employer contribution. Using this method will get you each employee's share of the employer contribution.

If you establish a profit-sharing plan, you:

  • Can have other retirement plans
  • Can be a business of any size
  • Need to annually file a Form 5500

As with 401(k) plans, you can make a profit-sharing plan as simple or as complex as you want. You may purchase a pre-approved profit-sharing plan document from a benefits professional or financial institution to cut down on administrative headaches.

What Are the Benefits?

Profit-sharing plans enjoy the usual advantages of other types of qualified retirement plans, including employer contributions that are tax deductible (within limits) and not taxed to the employee when they’re made. Investment earnings also accumulate on a tax-deferred basis.

Profit-sharing plans are generally attractive to companies with relatively young owner-employees, widely fluctuating profits, and a desire to avoid being committed to annual contributions. Another attractive option is the opportunity to include a 401(k) feature that permits employees to make elective salary deferrals to the plan.

Profit-sharing plans offer a convenient, tax-advantaged way to prepare for retirement, while still allowing contribution decisions to be based on sound business practices.

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The Concept

  • Profit-sharing plans are employer-sponsored qualified retirement plans in which the amount of each employee’s retirement benefit is determined by the employer’s contributions and the investment performance of the employee’s account.
  • Although employers are not required to contribute to a profit-sharing plan each year, they must make “recurring and substantial” contributions—at least three of every five years usually satisfies this requirement.
  • Many profit-sharing plans allow employees to invest and manage their accounts. Regardless of whether the employee or the employer manages the plan assets, the employee bears the risk of investment performance.

The Design

  • In a profit-sharing plan, the employer has great flexibility in determining how and when to make contributions. For example, a company may base contributions on profits exceeding a certain amount, or the board of directors may determine the contribution each year.
  • Deductible employer contributions cannot be more than 25% of a participating employee’s total compensation.
  • Employers often base contributions on the employee’s total compensation including salary, commissions, bonuses, overtime pay, etc. The maximum compensation to be taken into account for any one employee is $330,000 in 2023.
  • There are also limits on annual additions to defined contribution plans, which may not exceed the lesser of 100% of the employee’s compensation or $66,000 for 2023. This dollar amount is indexed annually for inflation.

The Tax Picture

  • Employer contributions are tax deductible within the 25%-of-compensation limit.
  • Employer contributions are not taxed to employees when they are made.
  • Investment earnings in the plan accumulate on a tax-deferred basis.

The Benefits

  • Employers can manage costs based on profitability or the discretion of the board.
  • Employees may be motivated when they share in company profits.
  • Employees enjoy greater flexibility than a typical pension plan, including the possibility of rolling the account balance into a new employer’s plan if the employee changes jobs.

The Bottom Line

Profit-sharing plans are particularly attractive to companies with widely fluctuating profits and a desire to avoid a fixed annual contribution requirement. The employer may choose to include a 401(k) feature permitting employees to make elective salary deferrals to supplement employer contributions.

Pros and cons

  • Flexible contributions – contributions are strictly discretionary
  • Good plan if cash flow is an issue
  • Administrative costs may be higher than under more basic arrangements (SEP or SIMPLE IRA plans)
  • Need to test that benefits do not discriminate in favor of the highly compensated employees.

Who contributes
Employer contributions only. If a salary deferral feature is added to a profit-sharing plan, it is a "401(k) plan."

Contribution limits
The lesser of 100% of compensation or $69,000 for 2024 (subject to cost-of-living adjustments for later years).

Filing requirements 
Annual filing of a Form 5500-series return/report is required. Participant disclosures are also required.

Participant loans 
Permitted.

In-service withdrawals
Yes, but subject to possible 10% additional tax if under age 59-1/2 and no other exception applies.

For further reading, visit: https://www.irs.gov/retirement-plans/choosing-a-retirement-plan-profit-sharing-plan

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