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401(K) PLAN
Plain English Explanation and Comment
A 401(k) plan is a special kind of defined contribution plan which allows for so-called "elective contributions." These are employee contributions which are made on a pre-tax basis to the plan. A 401(k) plan is a defined contribution plan (or "individual account plan"). It is almost always a part of a Profit Sharing Plan, although the plan of which it is a part might not provide for any employer contributions. A 401(k) plan is sometimes described as a "CODA."
An employer may establish a defined contribution plan that is a "cash or deferred arrangement", usually called a 401(k) plan. Under such a plan, a participant can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes, to the 401(k) plan. Sometimes the employer may match their contributions. There are special rules governing the operation of a 401(k) plan. For example, there is a dollar limit on the amount a participant may elect to defer each year. The dollar limit in $15,500 in 2008. A "catch-up" extra limit of $5,000 is also available for individuals who are or will turn 50 years of age during the calendar year The amount is adjusted annually by the Treasury Department to reflect changes in the cost of living. Other limits may apply to the amount that may be contributed on a participant's behalf. For example, if the participant is highly compensated, they may be limited depending on the extent to which rank and file employees participate in the plan. An employer must advise participant's of any limits that may apply to them.
Although a 401(k) plan is a retirement plan, participants may be permitted access to funds in the plan before retirement. For example, if a participant is an active employee, the plan may allow them to borrow from the plan. Also, the plan may permit a withdrawal on account of hardship, generally from the funds the participant contributed. The sponsor may want to encourage participation in the plan, but it cannot make participants' elective deferrals a condition for the receipt of other benefits, except for matching contributions.
Definition or Reference from the Text of ERISA and/or the Internal Revenue Code:
ERISA:
ERISA does not specifically refer to 401(k) plans
Internal Revenue Code
401 (k) Cash or deferred arrangements
(1) General rule
A profit-sharing or stock bonus plan,
a pre-ERISA money purchase
plan, or a rural cooperative plan shall not be considered as
not
satisfying the requirements of subsection (a) merely because
the
plan includes a qualified cash or deferred arrangement.
(2)
Qualified cash or deferred arrangement
A qualified cash or deferred
arrangement is any arrangement
which is part of a profit-sharing or stock bonus plan, a pre-ERISA
money purchase plan, or a rural cooperative plan which meets
the
requirements of subsection (a)--
(A) under
which a covered employee may elect to have the
employer make payments as
contributions to a trust under the
plan on behalf of the employee, or to
the employee directly in
cash;
(B) under
which amounts held by the trust which are
attributable to employer
contributions made pursuant to the
employee's election--
(i) may not be distributable to participants or other
beneficiaries
earlier than--
(I) severance from employment, death, or disability,
(II) an event described in paragraph (10),
(III) in the case of a profit-sharing or stock bonus
plan, the attainment of age 59\1/2\, or
(IV) in the case of contributions to a profit-
sharing or stock bonus plan to which section 402(e)(3)
applies, upon hardship of the employee, and
(ii) will not be distributable merely by reason of the
completion of
a stated period of participation or the lapse
of a fixed
number of years;
(C) which
provides that an employee's right to his accrued
benefit derived from employer
contributions made to the trust
pursuant to his election is
nonforfeitable, and
(D) which
does not require, as a condition of participation
in the arrangement, that an employee
complete a period of
service with the employer (or
employers) maintaining the plan
extending beyond the period permitted
under section 410(a)(1)
(determined without regard to
subparagraph (B)(i) thereof).
(3) Application of participation and
discrimination
standards
(A) A cash or
deferred arrangement shall not be treated as a
qualified cash or deferred
arrangement unless--
(i) those employees eligible to benefit under the
arrangement
satisfy the provisions of section 410(b)(1), and
(ii) the actual deferral percentage for eligible highly
compensated
employees (as defined in paragraph (5)) for the
plan year
bears a relationship to the actual deferral
percentage
for all other eligible employees for the
preceding
plan year which meets either of the following
tests:
(I) The actual deferral percentage for the group of
eligible highly compensated employees is not more than
the actual deferral percentage of all other eligible
employees multiplied by 1.25.
(II) The excess of the actual deferral percentage
for the group of eligible highly compensated employees
over that of all other eligible employees is not more
than 2 percentage points, and the actual deferral
percentage for the group of eligible highly compensated
employees is not more than the actual deferral
percentage of all other eligible employees multiplied by
2.
If 2 or more plans which
include cash or deferred arrangements
are
considered as 1 plan for purposes of section 401(a)(4)
or 410(b),
the cash or deferred arrangements included in
such plans
shall be treated as 1 arrangement for purposes of
this
subparagraph.
If any highly compensated employee is
a participant under 2 or
more cash or deferred arrangements of
the employer, for purposes
of determining the deferral
percentage with respect to such
employee, all such cash or deferred
arrangements shall be
treated as 1 cash or deferred
arrangement. An arrangement may
apply clause (ii) by using the plan
year rather than the
preceding plan year if the employer
so elects, except that if
such an election is made, it may not
be changed except as
provided by the Secretary.
(B) For
purposes of subparagraph (A), the actual deferral
percentage for a specified group of
employees for a plan year
shall be the average of the ratios
(calculated separately for
each employee in such group) of--
(i) the amount of employer contributions actually paid
over to the
trust on behalf of each such employee for such
plan year, to
(ii) the employee's compensation for such plan year.
(C) A cash or
deferred arrangement shall be treated as
meeting the requirements of
subsection (a)(4) with respect to
contributions if the requirements of
subparagraph (A)(ii) are
met.
(D) For
purposes of subparagraph (B), the employer
contributions on behalf of any
employee--
(i) shall include any employer contributions made
pursuant to
the employee's election under paragraph (2), and
(ii) under such rules as the Secretary may prescribe,
may, at the
election of the employer, include--
(I) matching contributions (as defined in
401(m)(4)(A)) which meet the requirements of paragraph
(2)(B) and (C), and
(II) qualified nonelective contributions (within the
meaning of section 401(m)(4)(C)).
(E) For
purposes of this paragraph, in the case of the first
plan year of any plan (other than a
successor plan), the amount
taken into account as the actual
deferral percentage of
nonhighly compensated employees for
the preceding plan year
shall be--
(i) 3 percent, or
(ii) if the employer makes an election under this
subclause,
the actual deferral percentage of nonhighly
compensated
employees determined for such first plan year.
(F) Special
rule for early participation.--If an employer
elects to apply section 410(b)(4)(B)
in determining whether a
cash or deferred arrangement meets
the requirements of
subparagraph (A)(i), the employer
may, in determining whether
the arrangement meets the
requirements of subparagraph (A)(ii),
exclude from consideration all
eligible employees (other than
highly compensated employees) who
have not met the minimum age
and service requirements of section
410(a)(1)(A).
(G) A
governmental plan (within the meaning of section
414(d)) maintained by a State or
local government or political
subdivision thereof (or agency or
instrumentality thereof) shall
be treated as meeting the
requirements of this paragraph.
(4) Other requirements
(A) Benefits (other than matching
contributions) must not be
contingent on election to defer
A cash or
deferred arrangement of any employer shall not be
treated as a qualified cash or
deferred arrangement if any other
benefit is conditioned (directly or
indirectly) on the employee
electing to have the employer make or
not make contributions
under the arrangement in lieu of
receiving cash. The preceding
sentence shall not apply to any
matching contribution (as
defined in section 401(m)) made by
reason of such an election.
(B) Eligibility of State and local
governments and tax-exempt
organizations
(i)
Tax-exempts eligible
Except as provided in clause (ii), any organization
exempt from
tax under this subtitle may include a qualified
cash or
deferred arrangement as part of a plan maintained by
it.
(ii)
Governments ineligible
A cash or deferred arrangement shall not be treated as a
qualified
cash or deferred arrangement if it is part of a
plan
maintained by a State or local government or political
subdivision
thereof, or any agency or instrumentality
thereof. This
clause shall not apply to a rural cooperative
plan or to a
plan of an employer described in clause (iii).
(iii)
Treatment of Indian tribal governments
An employer which is an Indian tribal government (as
defined in
section 7701(a)(40)), a subdivision of an Indian
tribal
government (determined in accordance with section
7871(d)), an
agency or instrumentality of an Indian tribal
government or
subdivision thereof, or a corporation
chartered
under Federal, State, or tribal law which is owned
in whole or
in part by any of the foregoing may include a
qualified
cash or deferred arrangement as part of a plan
maintained by
the employer.
(C) Coordination with other plans
Except as
provided in section 401(m), any employer
contribution made pursuant to an
employee's election under a
qualified cash or deferred
arrangement shall not be taken into
account for purposes of determining
whether any other plan meets
the requirements of section 401(a) or
410(b). This subparagraph
shall not apply for purposes of
determining whether a plan meets
the average benefit requirement of
section 410(b)(2)(A)(ii).
(5) Highly compensated employee
For purposes of this subsection, the
term ``highly compensated
employee'' has the meaning given such term by section 414(q).
(6) Pre-ERISA money purchase plan
For purposes of this subsection, the
term ``pre-ERISA money
purchase plan'' means a pension plan--
(A) which is
a defined contribution plan (as defined in
section 414(i)),
(B) which was
in existence on June 27, 1974, and which, on
such date, included a salary
reduction arrangement, and
(C) under
which neither the employee contributions nor the
employer contributions may exceed the
levels provided for by the
contribution formula in effect under
the plan on such date.
(7) Rural cooperative plan
For purposes of this subsection--
(A) In general
The term
``rural cooperative plan'' means any pension plan--
(i) which is a defined contribution plan (as defined in
section
414(i)), and
(ii) which is established and maintained by a rural
cooperative.
(B) Rural cooperative defined
For purposes
of subparagraph (A), the term ``rural
cooperative'' means--
(i) any organization which--
(I) is engaged primarily in providing electric
service on a mutual or cooperative basis, or
(II) is engaged primarily in providing electric
service to the public in its area of service and which
is exempt from tax under this subtitle or which is a
State or local government (or an agency or
instrumentality thereof), other than a municipality (or
an agency or instrumentality thereof),
(ii) any organization described in paragraph (4) or (6)
of section
501(c) and at least 80 percent of the members of
which are
organizations described in clause (i),
(iii) a cooperative telephone company described in
section
501(c)(12),
(iv) any organization which--
(I) is a mutual irrigation or ditch company
described in section 501(c)(12) (without regard to the
85 percent requirement thereof), or
(II) is a district organized under the laws of a
State as a municipal corporation for the purpose of
irrigation, water conservation, or drainage, and
(v) an organization which is a national association of
organizations
described in clause (i), (ii),,\4\ (iii), or
(iv).
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\4\ So in original.
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(C) Special rule for certain
distributions
A rural
cooperative plan which includes a qualified cash or
deferred arrangement shall not be
treated as violating the
requirements of section 401(a) or of
paragraph (2) merely by
reason of a hardship distribution or
a distribution to a
participant after attainment of age
59\1/2\. For purposes of
this section, the term ``hardship
distribution'' means a
distribution described in paragraph
(2)(B)(i)(IV) (without
regard to the limitation of its
application to profit-sharing or
stock bonus plans).
(8) Arrangement not disqualified if excess
contributions
distributed
(A) In general
A cash or
deferred arrangement shall not be treated as
failing to meet the requirements of
clause (ii) of paragraph
(3)(A) for any plan year if, before
the close of the following
plan year--
(i) the amount of the excess contributions for such plan
year (and any
income allocable to such contributions) is
distributed,
or
(ii) to the extent provided in regulations, the employee
elects to
treat the amount of the excess contributions as an
amount
distributed to the employee and then contributed by
the employee
to the plan.
Any distribution of excess
contributions (and income) may be
made without regard to any other
provision of law.
(B) Excess contributions
For purposes
of subparagraph (A), the term ``excess
contributions'' means, with respect
to any plan year, the excess
of--
(i) the aggregate amount of employer contributions
actually paid
over to the trust on behalf of highly
compensated
employees for such plan year, over
(ii) the maximum amount of such contributions permitted
under the
limitations of clause (ii) of paragraph (3)(A)
(determined
by reducing contributions made on behalf of
highly
compensated employees in order of the actual deferral
percentages
beginning with the highest of such percentages).
(C) Method of distributing excess
contributions
Any
distribution of the excess contributions for any plan
year shall be made to highly
compensated employees on the basis
of the amount of contributions by, or
on behalf of, each of such
employees.
(D) Additional tax under section
72(t) not to apply
No tax shall
be imposed under section 72(t) on any amount
required to be distributed under this
paragraph.
(E) Treatment of matching
contributions forfeited by reason of
excess deferral or contribution
For purposes
of paragraph (2)(C), a matching contribution
(within the meaning of subsection
(m)) shall not be treated as
forfeitable merely because such
contribution is forfeitable if
the contribution to which the
matching contribution relates is
treated as an excess contribution
under subparagraph (B), an
excess deferral under section
402(g)(2)(A), or an excess
aggregate contribution under section
401(m)(6)(B).
(F) Cross reference
For excise
tax on certain excess contributions, see section
4979.
(9) Compensation
For purposes of this subsection, the
term ``compensation'' has
the meaning given such term by section 414(s).
(10)
Distributions upon termination of plan
(A) In general
An event
described in this subparagraph is the termination
of the plan without establishment or
maintenance of another
defined contribution plan (other than
an employee stock
ownership plan as defined in section
4975(e)(7)).
(B) Distributions must be lump sum
distributions
(i) In
general
A termination shall not be treated as described in
subparagraph
(A) with respect to any employee unless the
employee
receives a lump sum distribution by reason of the
termination.
(ii) Lump-sum
distribution
For purposes of this subparagraph, the term ``lump-sum
distribution'' has the meaning given such term by section
402(e)(4)(D)
(without regard to subclauses (I), (II), (III),
and (IV) of
clause (i) thereof). Such term includes a
distribution
of an annuity contract from--
(I) a trust which forms a part of a plan described
in section 401(a) and which is exempt from tax under
section 501(a), or
(II) an annuity plan described in section 403(a).
(11) Adoption of simple plan to meet nondiscrimination tests
(A) In general
A cash or
deferred arrangement maintained by an eligible
employer shall be treated as meeting
the requirements of
paragraph (3)(A)(ii) if such
arrangement meets--
(i) the contribution requirements of subparagraph (B),
(ii) the exclusive plan requirements of subparagraph
(C), and
(iii) the vesting requirements of section 408(p)(3).
(B) Contribution requirements
(i) In
general
The requirements of this subparagraph are met if, under
the
arrangement--
(I) an employee may elect to have the employer make
elective contributions for the year on behalf of the
employee to a trust under the plan in an amount which is
expressed as a percentage of compensation of the
employee but which in no event exceeds the amount in
effect under section 408(p)(2)(A)(ii),
(II) the employer is required to make a matching
contribution to the trust for the year in an amount
equal to so much of the amount the employee elects under
subclause (I) as does not exceed 3 percent of
compensation for the year, and
(III) no other contributions may be made other than
contributions described in subclause (I) or (II).
(ii) Employer
may elect 2-percent nonelective
contribution
An employer shall be treated as meeting the requirements
of clause (i)(II)
for any year if, in lieu of the
contributions
described in such clause, the employer elects
(pursuant to
the terms of the arrangement) to make
nonelective
contributions of 2 percent of compensation for
each employee
who is eligible to participate in the
arrangement
and who has at least $5,000 of compensation from
the employer
for the year. If an employer makes an election
under this
subparagraph for any year, the employer shall
notify
employees of such election within a reasonable period
of time
before the 60th day before the beginning of such
year.
(iii)
Administrative requirements
(I) In general
Rules similar to the rules of subparagraphs (B) and
(C) of section 408(p)(5) shall apply for purposes of
this subparagraph.
(II) Notice of election period
The requirements of this subparagraph shall not be
treated as met with respect to any year unless the
employer notifies each employee eligible to participate,
within a reasonable period of time before the 60th day
before the beginning of such year (and, for the first
year the employee is so eligible, the 60th day before
the first day such employee is so eligible), of the
rules similar to the rules of section 408(p)(5)(C) which
apply by reason of subclause (I).
(C) Exclusive plan requirement
The
requirements of this subparagraph are met for any year
to which this paragraph applies if no
contributions were made,
or benefits were accrued, for
services during such year under
any qualified plan of the employer on
behalf of any employee
eligible to participate in the cash
or deferred arrangement,
other than contributions described in
subparagraph (B).
(D) Definitions and special rule
(i)
Definitions
For purposes of this paragraph, any term used in this
paragraph
which is also used in section 408(p) shall have
the meaning
given such term by such section.
(ii)
Coordination with top-heavy rules
A plan meeting the requirements of this paragraph for
any year
shall not be treated as a top-heavy plan under
section 416
for such year if such plan allows only
contributions
required under this paragraph.
(12) Alternative methods of meeting
nondiscrimination
requirements
(A) In general
A cash or
deferred arrangement shall be treated as meeting
the requirements of paragraph (3)(A)(ii)
if such arrangement--
(i) meets the contribution requirements of subparagraph
(B) or (C),
and
(ii) meets the notice requirements of subparagraph (D).
(B) Matching contributions
(i) In
general
The requirements of this subparagraph are met if, under
the
arrangement, the employer makes matching contributions
on behalf of
each employee who is not a highly compensated
employee in
an amount equal to--
(I) 100 percent of the elective contributions of the
employee to the extent such elective contributions do
not exceed 3 percent of the employee's compensation, and
(II) 50 percent of the elective contributions of the
employee to the extent that such elective contributions
exceed 3 percent but do not exceed 5 percent of the
employee's compensation.
(ii) Rate for
highly compensated employees
The requirements of this subparagraph are not met if,
under the
arrangement, the rate of matching contribution
with respect
to any elective contribution of a highly
compensated
employee at any rate of elective contribution is
greater than
that with respect to an employee who is not a
highly
compensated employee.
(iii)
Alternative plan designs
If the rate of any matching contribution with respect to
any rate of
elective contribution is not equal to the
percentage
required under clause (i), an arrangement shall
not be
treated as failing to meet the requirements of clause
(i) if--
(I) the rate of an employer's matching contribution
does not increase as an employee's rate of elective
contributions increase, and
(II) the aggregate amount of matching contributions
at such rate of elective contribution is at least equal
to the aggregate amount of matching contributions which
would be made if matching contributions were made on the
basis of the percentages described in clause (i).
(C) Nonelective contributions
The
requirements of this subparagraph are met if, under the
arrangement, the employer is
required, without regard to whether
the employee makes an elective
contribution or employee
contribution, to make a contribution
to a defined contribution
plan on behalf of each employee who
is not a highly compensated
employee and who is eligible to
participate in the arrangement
in an amount equal to at least 3
percent of the employee's
compensation.
(D) Notice requirement
An
arrangement meets the requirements of this paragraph if,
under the arrangement, each employee
eligible to participate is,
within a reasonable period before any
year, given written notice
of the employee's rights and
obligations under the arrangement
which--
(i) is sufficiently accurate and comprehensive to
apprise the
employee of such rights and obligations, and
(ii) is written in a manner calculated to be understood
by the
average employee eligible to participate.
(E) Other requirements
(i)
Withdrawal and vesting restrictions
An arrangement shall not be treated as meeting the
requirements
of subparagraph (B) or (C) of this paragraph
unless the
requirements of subparagraphs (B) and (C) of
paragraph (2)
are met with respect to all employer
contributions
(including matching contributions) taken into
account in
determining whether the requirements of
subparagraphs
(B) and (C) of this paragraph are met.
(ii) Social
security and similar contributions not
taken into account
An arrangement shall not be treated as meeting the
requirements
of subparagraph (B) or (C) unless such
requirements
are met without regard to subsection (l), and,
for purposes
of subsection (l), employer contributions under
subparagraph
(B) or (C) shall not be taken into account.
(F) Other plans
An
arrangement shall be treated as meeting the requirements
under subparagraph (A)(i) if any
other plan maintained by the
employer meets such requirements with
respect to employees
eligible under the arrangement.